Written by Greg Crabtree
The problem with cash flow is that it lags behind profit for most businesses. Unless your customers pay you and you pay your vendors at exactly the same moment, there will always be a time lag. If you understand the correct order of priority for cash flow, you will avoid the disconnect.
If you are profitable, you must understand that there are four forces that demand satisfaction out of your cash flow – and I can also assume they are in opposite order to what you would prefer:
1. Taxes– You must either set aside money or pay chunks of taxes as you go to avoid the April surprise (or October surprise if you extend how long you stick your head in the sand)
2. Debt– Lines of credit are crack cocaine for entrepreneurs: get off the drug as soon as you can
3. Core Capital– retain after-tax profits until you reach your core capital target, which is generally defined as 2 months of operating costs in cash with nothing drawn on the line of credit and your anticipated taxes set aside
4. Distributions– Reap your reward and finally take after tax profits to diversify your wealth outside of the business
If you did not pay any taxes, you either didn’t make any money or you cheated: both are bad. The biggest hindrance to paying taxes is the complexity of the tax code; the second is not planning to set aside cash for paying the taxes. That is why you should monitor your profitability each quarter and determine how much to set aside or pay in, depending on the rules.
Try to pay only what is required at the last possible moment to not incur a penalty, but that also means you have to know to set taxes aside as profit is earned. Get your tax advisor to do this for you each quarter – it will be worth it.
Poor management of debt has killed many good businesses. It is like a drug in that it allows you to postpone the hard decisions too long before you are forced to make them when you run out of credit. I do not recommend funding losses with line of credit financing. It is OK to use lines of credit to fund profitable growth, but the moment you use a line to cover a monthly loss, you have started down a slope that too often ends badly. Make the hard decisions sooner!
The other key about debt is knowing that you can only repay debt with after-tax profits, with very few exceptions. This is a big hit to most entrepreneurs who have a great year and think they can use 100% of all their pre-tax income to pay off debt.
As for term debt, only use this debt when you are purchasing a necessary asset and the payments truly reflect the cost of using that asset over its useful life.
Somewhere along the way, it is important to find out the simple calculation that lets you know what a healthy business is. Your business may be profitable, but if you are pulling all of your cash out of the business for the wrong reasons, you will find your cash cow is out of milk when a downturn happens. The deepest downstroke in operating cash flows for most businesses is equal to two months of operating expenses.
In turn, I recommend setting the “core capital target” at two months of operating expenses in cash, in addition to owing nothing on the line of credit and setting aside any tax amount currently due. You may want to set the target higher, but you would never set it lower.
Once you have taken care of the first three cash flow forces, you get to enjoy the fruit of your labor. You can now use those after tax profits that the business does not need to diversify your wealth. Notice I said diversify, not consume! Unless you have multiple sources of income beyond your needs, the moment you are looking to the profits of your business to meet your consumption needs, you have headed down a dangerous path. This is why it is important to pay yourself a market-based wage for the “job” you do in your business and live off your salary. When your business has profits to distribute, you should first use it to eliminate personal debt and then to build assets outside of the business.
In summary, once you are profitable, it is taxes, debt, core capital and then you can have a distribution. It is a great formula for building lasting wealth from your entrepreneurial efforts, and keeping your cash cow healthy for years to come.
About the Author: Greg Crabtree has worked in the financial industry for more than thirty years and founded Crabtree, Rowe & Berger, PC, a CPA firm dedicated to helping entrepreneurs build the economic engine of their business. In addition to serving as the firm’s CEO, Crabtree leads the business consulting team—helping clients align their financial goals with their profit model and their core business values. He is the author of Simple Numbers, Straight Talk, Big Profits!For more information, please visit: http://www.seeingbeyondnumbers.com/.