ANTHONY TUMBIOLO

Finance

Managing Cash Flow and Ensuring a Profit

Managing cash flow is critical to running a business. If not done correctly, it can kill your business. Over the years I created and refined my system for managing cash flow. While there’s a lot of factors to success in business, I can say that my ability to manage cash flow has been key, especially in rougher times (e.g., sales not closing, clients leaving, etc.), resulting in being profitable every year since I started Jakt 7 years ago. The system has evolved over time. I am constantly looking to improve upon systems so that this system could have adjustments in the future, and therefore this will be a living doc that over time gets updated. The system below is based on the latest version that we currently use at Jakt today.

Managing Cash Flow Each Month

I recommend having a minimum of five accounts:

  • Revenue
  • Expenses
  • Taxes
  • Retained Earnings
  • Profit to be distributed

Revenue

Every dollar we get paid goes into the Revenue account.

Going into each month, I know exactly the amount of expenses we will have. Expenses will never go above that amount each month. Unless there is some unexpected event that is a unique occurrence or because we closed more business. The latter case is ok because it means there’s corresponding revenue coming in to cover these expenses. Having confidence in the dollar amount of your expenses for the month is very important — the less variance within a month the better which can give you confidence in how you move money throughout the month.

Expenses

Because I know what my monthly expenses will be for the month ahead, I then move money from the “Revenue” account to the “Expenses” account until I’m moved enough money from the Revenue account to the Expenses account that month such that all the projected Expenses for the month are covered.

For example, if I know my expenses next month will be $25,000, the first $25,000 in revenue we collect gets moved into the Expenses account.

Taxes and Retained Earnings

Once the projected monthly expenses are completely covered, I move any additional money received.

  • 40% of the Revenue goes into the tax account (my estimated taxes each year are around this so I make sure to set aside 40% of any profit for paying taxes later)
  • 60% gets moves into the Retained Earnings account

I like to keep a minimum of 1-month cash in the “Retained Earnings” account. Less than this is a bit scary for me. More than three months is a bit too much in my opinion. At that point, you have too much cash sitting there and not being invested.

Building up a Retained Earnings account is important because 1) if you have a bad cash flow month, then you have this safety net and 2) if you want to make some investments into your business, you have cash on hand to do it.

Profits

Once we have reached our Retained Earnings threshold, then the remaining funds go into “Profit to be distributed”.

The flow then becomes:

  • 40% of the Revenue goes into the tax account
  • 60% moves into the Profits to be distributed account

Once we have reached our Retained Earnings threshold, then the remaining funds go into “Profit to be distributed.”

The “Profit to be distributed” is how I as the owner get paid. I take money last. And the money I take out is tax-free because I’ve already set aside 40% for taxes.

The “Profit to be distributed” is how I live and I use that money on anything else I need it for outside of the business. This ensures that I never take out more than the business needs.

I believe the owner should be paid last. Some people disagree with me here, but it’s served me well since I started.

The way I see it, if you need money each month, make sure the business is making a profit.

I’ve seen too many people take money out of the business thinking “we will make a ton in the next few months” then those future months don’t go well. Then they’ve taken money out of the company and either 1) have to put it back or 2) if they can’t put it back in because they’ve spent it, they now have a huge problem.

 

Common Questions and Answers

In this section, I will answer FAQs. If you don’t see a question you have, feel free to comment on the post and I will answer.

How often should you rebalance and move money according to the flow above?

Weekly.

I recommend weekly. So you are keeping an eye on cash every single week and ensuring you are managing your cash balances and running a healthy business.

How often should I distribute profits from the “Profits to be distributed account”?

Distributing profits is a bit of a personal choice. In the early days of the business, I did this monthly at the end of the month. Partly because there would be no money in that account because I needed to put money into the “Expenses” account and “Retained Earnings” accounts in the earlier weeks of the month. I also usually wouldn’t take out the entire amount each month just in case the next month we lost a little bit of money. This would very rarely happen, but I like to play conservatively.

Today I take profits out quarterly.

What do I do if one month I lose money?

You can either take that from the Retained Earnings account or put money in from your personal account.

If you take profits out quarterly, it’s less likely for this to happen. Losing money one month may occur (e.g., one customer is late on their payment to you and comes in the following month, but you still have to pay your employees) but losing money three straight months and ending the quarter on a loss shouldn’t. If it does, there are some more substantial issues to uncover.

Today I distribute profits quarterly because I don’t need money coming in each month.

How do you initially build up the Retained Earnings account to have at least one months expenses?

In the early days when you have 0 cash balance and need to build that up, virtually all money above expenses should go into retained earnings. You should be taking as little as possible out of the business. If you need a certain amount of living money, after you pay all expenses to take exactly the amount you need for expenses out (as little as possible) and the rest goes into retained earnings account until it is built up. This is key especially as you start growing and want to hire more people, outlay cash for some equipment, etc.

As you grow, your expenses will rise, and therefore the dollar amount needed in the Retained Earnings account will increase. Make sure you don’t take out too much from your business prematurely. Delayed gratification on this will pay dividends later, and the dollar amount in profits you’ll be able to take out will be much, much higher. At least that’s been my experience.

How do I ensure I will have excess money for Retained Earnings and Profits to be distributed?

This is where a firm understanding of how a Profit & Loss (P&L) statement is essential.

Revenue – Expenses = Profit (money left over for retained earnings and distributed profits).

I like to work backward on the P&L. I first ask, how much profit do I want? So for example, if I’d like to maintain a 20% margin, I ask myself, what needs to happen such that this is true? You can also ask the question if I want to make a specific dollar amount in profit each month (e.g., if I want to make $10,000 a month in profit each month), what needs to happen such that this is true?

For the rest of this example, we’ll look at it from the goal of attaining a 20% profit margin.

So assuming we want a 20% margin, I then look to my projections for revenue, cost of goods sold (cogs) and operating expenses. They all work very closely together to help achieve that 20% margin. It’s a simple formula, and revenue, cogs and operating expenses are the variables you can play with.

You start with a pie of 100% (revenue, with no costs). Cogs and operating expenses subtract from that 100%. Leftover cash is profit. You then can play with the cogs and operating expenses to figure out different proportions on how you can achieve that 20%.

Example:

For example, to achieve a 20% margin you could have:

Revenue ($10,000 = 100%)

  • Cogs (50% = $5,000)
  • Operating Expenses (30% = $3,000)

Profit (20% = $2,000)

OR

Revenue ($10,000 = 100%)

  • Cogs (40% = $4,000)
  • Operating Expenses (40% = $4,000)

Profit (20% = $2,000)

As you can see, it’s a simple math equation that you can adjust. When looking at your business, you’ll have to make the decisions on how much to allocate towards cogs and how much to allocate towards operating expenses.

For Jakt, for example, our goal is to maintain a 20% profit margin. To do this, we have a goal of 50% cogs and 30% operating expenses.

If the system ever goes out of balance, we know we need to adjust. For example, if cogs go up to 55% one month we know, we must temporarily reduce operating expenses to 25% to maintain the 20% profit margin goal.

Knowing we can spend 50% on cogs and 30% on operating expenses to achieve our target gives us the parameters to play within. It helps us decide on everything from hiring, pricing, spending on marketing, etc.

There are too many scenarios to outline here, but if you understand the formula and variables, you’ll see that you can easily make decisions based on this.

What Are Some Questions You Can Answer from This System?

  • How much can you pay that freelancer?
  • What can you spend on marketing?
  • Can you spend on an accountant?
  • How much can you pay your employees?
  • Can you give your employees a raise? Or if you do, what else needs to change?
  • What happens if we lower prices?
  • What happens if we raise prices?
  • How many deals do we need to close to maintain this profit margin?
  • What has to happen if we don’t close that deal or the amount of money we thought we would?
  • Etc etc

But in general, virtually every question about “how much can we spend” comes back to this simple equation.

If you follow this formula and rebalance when needed, you will ensure there to be excess money after paid expenses.

Accrual and Cash Accounting: An Important Difference

Now, it’s critical to note that you must understand the difference between accrual and cash accounting.

We typically do this math based on accrual-based accounting which means that we will have billed for N dollars but not necessarily received it yet. If your cash collection system is good, you will have no issues. However, if someone is late to payment, for example, on a cash basis your margin may be less than 20% one month, and above 20% the following month when you collect that additional cash. Maintain Retained Earnings to help cover some of that cash when a customer is late paying.

Alternatively, you could renegotiate terms with your vendors. Re-negotiating with employees on salaries is not as easy (don’t do this). So long as customers do actually pay you and you have enough Retained Earnings to cover the difference until they do, you are fine. If you are not collecting cash from customers, even if on accrual basis you have a profit, you risk draining your Retained Earnings and potentially bring the business to a halt before you actually realize that profit. This is key, especially for service based businesses.

In short, keep paying attention to the accrual basis percentages to help decide on future spend, but don’t lose sight of the cash basis numbers and make adjustments when needed.

Some additional notes

  • This method I’ve outlined not take into account advanced strategies such as managing a line of credit. I’ll cover that in another post.
  • You can also add additional accounts as you see fit. The above is the minimum I’d recommend, but don’t feel scared to add more. For example, next year I’m adding a “Jakt team bonus” account.

Want me to help with your specific business and situation? Join the group at ServiceBasedBusinesses.com, and I’ll personally help you.