Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine

by Mike Michalowicz

Use Small Plates—When money comes into your main INCOME account, it simply acts as a serving tray for the other accounts. You then periodically disperse all the money from the INCOME account into different accounts in predetermined percentages. Each of these accounts has a different objective: one is for profit, one for owner compensation, another for taxes, and another for operating expenses. Collectively, these are the five foundational accounts (Income, Profit, Owner’s Comp, Tax, and Operating Expenses), and where you should get started, but advanced users will use additional accounts, outlined in Chapter 10.

Serve Sequentially—Always, always allocate money based upon the percentages to the accounts first. Never, ever, ever pay bills first. The money moves from the INCOME account to your PROFIT account, OWNER’S COMP, TAX, and OPEX (OPERATING EXPENSES). Then you pay bills only with what is available in the OPEX account. No exceptions. And if there isn’t enough money left for expenses? This does not mean you need to pull from the other accounts. What it does mean is that your business is telling you that you can’t afford those expenses and need to get rid of them. Eliminating unnecessary expenses will bring more health to your business than you can ever imagine.

Remove Temptation—Move your PROFIT account and other “tempting” accounts out of arm’s reach. Make it really hard and painful to get to that money, thereby removing the temptation to “borrow” (i.e., steal) from yourself. Use an accountability mechanism to prevent access, except for the right reason. Enforce a Rhythm—Do your allocations and payables twice a month (specifically, on the tenth and twenty-fifth). Don’t pay only when there is money piled up in the account. Get into a rhythm of allocating your income, and paying bills twice a month so that you can see how cash accumulates and where the money really goes. This is controlled recurring and frequent cash flow management, not by-the-seat-of-your-pants cash management.

Right now I want you to set up your PROFIT account. It is the first step in the Profit First system, so do it right now. Call your bank (or do it online) and set up one new checking account. Don’t get mired in whether it should be a savings account or a sweep account or any of that. The five seconds you spend thinking about it cost more than the little dribble of interest it will yield. Your goal is just to get started and not to slip back. After setting up this new checking account at your bank, nickname the account PROFIT, and from this moment forward from any deposit you put into your normal checking account, transfer 1 percent of that deposit into your PROFIT account. Then proceed with your business and processes and money management as you have in the past. Just add to the PROFIT account, and never touch it (until you get to the section of this book where I explain what to do with it). If you get a $1,000 deposit, I am telling you, starting today, transfer $10 into your PROFIT account. If you could run your business off $1,000, you can surely run it off $990. If you get $20,000 in deposits, you transfer $200 into your PROFIT account. If you can run your business off $20,000 you absolutely can run it off $19,800. You’ll never miss that 1 percent. It is a low bar. But something magical will happen. You will start proving the system to yourself. You won’t get rich overnight this way, but you will get a wealth of confidence. You will have a flavor of how powerful it is to...

Transfer 1 percent of your current money into the PROFIT account. You have “seeded” the account. Don’t touch it. Never transfer it. Just let it sit for now.

Profit First is, in part, the envelope system applied to business and modernized by using bank accounts. The system worked flawlessly for my mom, and I suspect it has done the same for someone in your family tree.

The default cash-management system for most entrepreneurs is what I call bank balance accounting. Ironically, it is what our accountants tell us not to do. “Don’t look at your bank accounts,” they say. “Look at your accounting system.”

If you follow your accountant’s directions explicitly, this is what is expected of you when you review your accounting system to figure out how much cash you have—once you have reconciled all accounts for accuracy, reviewed your profit and loss (P&L) and cash flow statements and then tie the numbers into your balance sheet. Next you’ll run the critical metrics, such as your OCR (operating cash ratio), inventory turn, and both the current ratio and quick ratio. Then you’ll tie those into your KPI (key performance indicators), and then you will know the health of your business. Oh, and before I forget, do that every week.

What do most entrepreneurs do? We revert to bank balance accounting. What is that? We log into our bank accounts, make note of our balances, and then, based upon what we see, make decisions on how to proceed. When our balance is low, we make collection calls and sell hard. When our balance is high, we invest in equipment and expansion. It works. Kinda.

Profit First is designed so that you can (and should) continue doing bank balance accounting. The system is set up with your bank accounts so that you can log in, see what your balance is, and make decisions accordingly. This is what you are doing already, so you don’t need to change. Profit First just has multiple accounts at your bank so that when you log in, you know what purpose that money is meant to serve. You open your “envelope,” see what you have to work with, and make your decisions. Will it be rice and beans or Wiener schnitzel? With Profit First, we are not going to change your behavior; we are going to put guardrails around it. We are not only going to allow you to do what you always have done; we are also going to encourage it.

Here are the five checking accounts you need to set up: INCOME PROFIT OWNER’S COMP TAX OPEX Make sure you set these up as checking accounts.

You can use your existing primary bank account as one of the five accounts. Rename it your OPEX account because you are likely paying all your bills from that account. Going forward, we are just going to move deposits to your INCOME account. That should be a no-brainer for check deposits; simply put them into a new account. For other types of deposits, such as credit card or ACH payments, you’ll have to update your bank information wherever necessary. The process will take about half an hour—if you have a lot of automated payments, maybe an hour. Make the effort and get this done.

Now that you’ve set up your five foundational accounts at your primary bank, your next step is to set up two “no-temptation accounts.” We are going to get your taxes out of sight and out of mind. And we are going to do the same with your PROFIT account. You may be thinking, “Why do I need to do this? I already have a TAX account and PROFIT account at my primary bank. Why do I need a duplicate?” The reason we have these secondary accounts is to keep the money that you allocate and reserve for tax and profit out of your sight. Because when something isn’t available to consume, you don’t consume it. If something is not readily available, we are unlikely to go through an extraordinary measure to consume it. Your profit is for you, and if you can access it easily, you might be tempted to “borrow” from it to cover expenses. And the tax money? That belongs to the government. We are going to make sure you never borrow (a soft term for “steal”) from these accounts.

If you take money from your PROFIT account and put it back into the business, you are basically saying that you are unwilling to find a way to run your business with the operating expenses you allocated for it. If you take money from your TAX account, the money you have reserved to pay the government, you are stealing from the government.

Find a new bank that you have never worked with before. In this case, you will not be moving money too much, and you will rarely bring the two accounts to a zero balance (unless you are short on tax). So with this bank, you can be less concerned about any minimum balance fees they have. At the second bank set up two savings accounts (this is where you will collect interest because your money will pool for a while). The two accounts are PROFIT HOLD and TAX HOLD. Then link these two accounts to the respective PROFIT and TAX accounts at your primary bank so that you are able to transfer money. I will explain shortly when to transfer money and how often you will do it. But for now, I want to address one question you may have. You may be thinking, “Why should I set up PROFIT and TAX accounts at both my primary bank and my no-temptation bank? I’m an entrepreneur! I like shortcuts! Can’t I just transfer money from my primary bank’s INCOME account to the PROFIT HOLD and TAX HOLD accounts at my no-temptation bank?” While technically speaking you can do that, it is a bad idea for two reasons.

Transfers from one bank to another are not instantaneous. It can take three days or longer (weekends and holidays add time), and when you log into your primary account, the money looks as if it is still there. The goal with Profit First is to give you instant and accurate knowledge on where your cash stands. When you move money from one account to another at the same bank, the transfer usually happens instantaneously. By first moving money from your INCOME account to the PROFIT and TAX accounts (along with the other accounts), you will instantly see where your money stands, on their respective plates. Now that your money is clearly on the right “plate” at your primary bank, initiate the transfer to the PROFIT HOLD and TAX HOLD accounts at the second bank. Now, anytime you log into your primary bank you will know exactly where you stand, even if the transfer to your no-temptation bank hasn’t completed yet.

“Can’t I just do this on a spreadsheet or in my accounting system? Why do I need to do this at the bank?”

I answer this question by asking a question: How has that served you so far? Aren’t you already following your cash flow every day on a spreadsheet? Are you not checking your accounting system daily, reviewing the numbers? No? Exactly. So setting up Profit First in your accounting system is only a slight modification over something you are supposedly “doing” already and failing at.

No matter what those spreadsheets or monthly reports say, your current bank balance is always going to be a stronger determinant of your behavior. The reason you must set up your Profit First accounts at your bank is because it is the only way to insert the system into your normal path of behavior. By setting...

When choosing your banks, focus on convenience options for one and inconvenience options for the other. At your primary bank, you want easy access to view your accounts (plates or envelopes). You want the easy ability to transfer money from INCOME to your other accounts. And you want to be able to pay bills out of OPEX. At your secondary bank, you want no convenience options. Remember: out of sight, out of mind.

Feedback from so many people who are implementing Profit First demonstrates that some (but very few) large banks will work with you by cutting out the fees. But many regional and local banks and federal credit unions will be thrilled to work with you, and in many cases (like my own experience), they don’t have all those crazy fees in the first place. Small banks and credit unions are plug and play for Profit First. Select big banks are, too.*

Here’s how to proceed: if you like your current bank, tell them that their requirements for a “minimum balance” and “transfer fees” and all those rules they have don’t work for you. Ask them to wave the minimum balance requirement and other fees. Yes, you can ask that. Your bank will either comply with your request, or they won’t. If they do, kudos to you. If they don’t, move on to a new bank.

Step 1: Set up the five foundational accounts: an INCOME account, a PROFIT account, an OWNER’S COMP account, a TAX account, and an OPEX account. In most cases, you will already have one or two accounts with your bank. Keep the primary checking account you already have as your OPEX Account, and set up the remaining accounts: INCOME, PROFIT, OWNER’S COMP, and TAX. For simplicity’s sake, set them all up as checking accounts. Some banks may charge fees or have minimum balance requirements. Don’t let that deter you. Ask to speak to the bank manager and negotiate the fees and requirements. If the manager is unwilling to negotiate, find a new bank.

Step 2: Set up two more external savings accounts with a bank other than the bank you use for daily operations. One account will be your no-temptation PROFIT HOLD account. The second will be your no-temptation TAX HOLD account. Set them up with the ability to withdraw money directly from the respective checking accounts at your primary bank. Step 3: Don’t enable any of the “convenience” options for your two external no-temptations accounts. You don’t need or want to view these accounts online. You don’t want checkbooks for these accounts. And you definitely do not want a debit card linked to those accounts. You just want to deposit your profit and tax reserves and forget it . . . for now.

Once Lisa set out on the Profit First path, she realized she wasn’t working to her best potential or serving her best audience. Like her money, her services were spread out all over the map. Lisa shifted her business audience and formed Ark Entertainment Media, a business incubator for creative entrepreneurs.

Profit First is a cash-management system. We don’t do anything on accrual or any of that funny-money stuff. It is really simple: Did you get the cash or not? And did you spend the cash or not? That’s it. Nothing else really matters unless cash happens. So that is why our focus is exclusively on cash. If you are wondering how Profit First addresses depreciation or accounts receivable, you are still thinking funny money. We are only going to measure actual cash transactions. Money in. Money out. Real money. Period.

Before you start the Instant Assessment, get your P&L from your last full year in business. Get the tax returns for each owner in the business for the tax period for that year. Get your balance sheet for the year-end of that year. Your accounting software (if you use one) can spit this stuff out easily; everything but your tax returns. If you don’t have access to a balance sheet or your P&L, that’s OK; we can still get darn close.