60% of small businesses have experienced a cash flow issue at some point, according to Quickbooks. As a result, cash flow management for solopreneurs and small business owners is a common pain point. However, with a cash flow system in place, it drives the ability to make proactive business decisions, creates opportunities, and allows your business to run at peak performance.
Planning tip: The #1 rule when managing money as a solopreneur or small business owner is to keep personal, and business expenses separate.
A cash flow system doesn’t have to be complex; it just needs to work. Simplicity is key. In our experience, one of the most simple cash flow systems to implement is Profit First. This concept was originally introduced in the book Profit First by Mike Michalowicz. If you haven’t read the book, it’s a highly recommended read.
The logic of taking profit first means you’ll focus more on your goals, priorities, and expenses. Then, you’ll quickly realize how profitable your business is, how lean it can run, and spot opportunities.
Here is a quick summary of the idea behind the profit first method:
What a solopreneurs cash flow usually looks like…
Income – Expenses = Profit (for most solopreneurs, this equals pay).
The problem with this equation is that you pay yourself with “what’s left.” Like managing personal finances, you want to pay yourself first. In other words, build in business profit first, and work from there.
The profit-first system looks like this…
Income – Profit = Expenses
In this equation, “what’s left” is your expenses. This locks in profit and pushes more focus on goals, priorities, and expenses. Resulting in a better understanding of your business’s financial health.
This post will lay the foundation for a simplified approach to cash flow management for solopreneurs and small business owners.
A cash flow system will allow you to account for each dollar of revenue in your business. Many times, solopreneurs dump all revenue into one account and blindly pay expenses. This is a quick way to lose the grip on your business. Instead, one way to organize your cash flows is to create accounts (or subaccounts) designed for your business. That brings us to step 1.
Option A. Set up five business bank accounts at the same bank (5 accounts?! Really? Stay with me.)
Option B. Set up one bank account that allows for subaccounts.
If your bank allows you to set up subaccounts under one main account, this can simplify your cash flow management system.
These 5 accounts are labeled — income, tax, profit, compensation, expenses.
Note: In the book “Profit First,” the tax and profit accounts are at a completely separate bank. This is so you don’t have easy access to the money. However, as long as you have accountability and a system to follow, we believe you can simplify this at one bank.
As your business grows, you can add different accounts such as payroll, emergency, projects, or anything else that applies to your business.
Once your accounts are established, you’ll need to determine an allocation percentage each. If you don’t know where to start, the below target allocation percentage table from the book Profit First will put you on the right path. Alternatively, if you have historical data from your business, you might use that information to determine an allocation to each account.
Target Allocation Percentages by Mike Michalowicz
Income Account. This is the main account or hub account. This account receives 100% of business revenue. If you use subaccounts, this will be the main account to which the following will be subaccounts. This balance will get zeroed out when allocations are made to the other accounts.
Profit Account. When implementing a cash flow system and taking a profit, start small. A 1-2% allocation is a good percentage to start with. Then, increase this gradually as your business grows or becomes more efficient.
Planning tip: Starting small to build momentum is important. You want to avoid extreme adjustments out of the gate, such as 0% to 10%. It’s easier to move up slowly than move back down and lose momentum.
Tax Account. You must pay taxes. There is no getting around Uncle Sam. Although, we argue that a good cash flow system will help spot opportunities that can potentially reduce your tax bill. The allocation to the tax account will depend on the business revenue. The allocation will likely be 10-20%. Start higher if you are unsure. You want to avoid having to come up with a lump sum of cash for taxes at tax time.
Planning tip: Using previous years’ business tax data, review your effective tax rate over the last few years. This will help you determine the appropriate allocation. Alternatively, and even better, have your tax or financial professional run a projection for you.
Compensation Account. This is the fun part — How much do you want to pay yourself? Base this allocation on how much you can comfortably afford to pay yourself and support your lifestyle. The allocation to this account will likely be 50-60% as a solopreneur.
Planning tip: If you are an LLC filing as S Corp, you pay yourself a reasonable wage. As a result, the compensation account might end up with a surplus after you’ve distributed your wages. In this case, at the end of the year, you can deploy the excess money to yourself, a retirement account, or reinvest in your business.
Expenses Account. Because you’ve allocated to the other parts of your business first, the remaining amount is theoretically what you have for expenses. Can you run your business with this amount? If not, it’s time to make adjustments.
This is a great time to understand the meaning of each expense and what expenses are pushing your business in the right direction. You might find that your business can run on much less money than you thought!
Depending on the size of your business, expenses will likely range from 20-40% of revenue.
The allocation percentages are not “set it and forget it.” You can and will make adjustments as you implement a cash flow management plan into your business. During implementation, you’ll learn a lot about the financial health of your business and quickly spot areas of opportunity.
BONUS! Retirement Account. If you have a solo 401k or another self-employed retirement account, you might build this into your cash flow system. A solo 401k can be a valuable tool for solopreneurs to diversify their business, build wealth and reduce tax. You can make contributions from the income account as regular employer contributions. Then make additional employer contributions at the end of the year based on business net income and excess money in your accounts. Work with your financial professional to determine how much you can contribute to these plans.
Once you have your percentages determined, your cash flow management system will look something like this.
Banks don’t allow automatic allocations to each account or subaccount (yet). Meaning, you’ll manually move money when you allocate your percentages to each account. Luckily, this only takes a few minutes. More importantly, it forces you to log in and see where money is going. Knowledge is power.
Making Allocations: How often you move money will vary based on your business. However, we recommend at least monthly since you likely have revenue and expenses each month. With the revenue that has come into your income account, you’ll send the percentage allocations to each account (or subaccount). Do this allocation on the same dates each month.
Note: In the book Profit First, they suggest making your allocations and distributions on the 10th and 25th of each month. Then every quarter, you take 50% of the profit account accumulation.
Profit: Disburse 50% of this account quarterly as a bonus to yourself. You can adjust this to your personal and business needs.
Taxes: Each quarter, you can disburse your tax account to pay quarterly estimated taxes.
Compensation: Determine how often to pay yourself — weekly, every 2 weeks, monthly. Then, you’ll disburse this account to your personal bank account on the same date every week or month.
Expenses: If you use a business credit card for all expenses, it’s easy to disburse the expense account once a month to pay for the credit card in full.
Planning Tip: If total expenses are less than the expense allocation, it’s ok to let the expense account build up. This maintains a natural buffer for the months you have higher expenses.
Automate as much as you can. As mentioned, there aren’t any banks that allow for automatic allocations between accounts or subaccounts (if you find one, let us know). However, you can automate expenses and transfers if your revenue is consistent. This will streamline your business so everything is paid on time and less you have to worry about.
Follow a system. A system allows you to act proactively and make decisions. When you have a system in place, you have less room for human error. The best system is the one you can follow.
Don’t cheat. When you allocate revenue to each account, don’t cheat yourself and borrow from one account to put in another. For example, never steal from your tax account to pay an expense.
Make adjustments. Just because you have a system in place doesn’t mean it won’t change. Your business will evolve and become more efficient. As the business grows or you hire, you’ll want to adjust the allocations to meet your needs.
Implementing a good cash flow management system will help you come to terms with the current health of your business and become more profitable.
Whether your business is starting fresh or going at it for years, a cash flow management system will take a lot of stress of your finances. If you want to explore how we help solopreneurs and small business owners get more out of their money, let’s chat!