How to allocate your cash flow like a pro

Feast to famine is no way to live.  If you're self-employed, you need to pay yourself first, otherwise, why are you in business anyway?

I had the pleasure of speaking with Jen Percival @women_rocking_real_estate about this topic for her podcast, where we discuss money, mindset, and a profit model that can work for you. You can listen to it here.  I've captured the discussion we had around a watered-down approach to the Profit First model designed by Mike Michaelowicz that you can implement right now so you can start to create a steady income stream and support your business.  

 As an entrepreneur, you’ve likely had to overcome a few financial hurdles to turn your passion into profit.  But once you start to gain traction and win a few clients (hello, cash flow!), it’s not time to buy a new car or blow it all on a shopping spree.  Yes, you can celebrate your success with a small splurge, but this is the best time to implement an income allocation system that will provide you peace of mind in the long run. 

 My approach is less rigid than the model in Profit First and it’s for entrepreneurs looking for a quick system to start right now.  If you want to go deeper on the topic, I highly recommend reading the book.

 I love the idea of the Profit First model for two reasons:

1. It’s a model I’ve applied to my own money management system for years
2. It turns the traditional GAAP (generally accepted accounting principles) on its head, and as much as I admire accountants (including my brother-in-law), sometimes the “old way” isn’t the “best way”.

 

Here’s the crazy new idea: instead of paying all your bills and taxes first and using what’s left over to pay yourself, you pay yourself first, and your bills and taxes follow.

The Profit Model sweet spot: how to allocate your money

There are 4 different accounts that you will set up at your bank, and with each deposit, you allocate according to these guidelines:

 

1. Your pay: 20-25%. This is probably the most volatile of all the buckets but the most important one to maintain.  Now to be clear, this doesn’t mean receiving all your income in one 20% dump – it means allocating this amount after each sale so you can then draw an income from the account.  That amount YOU determine.
2. Profit: 3-5% Think of this as your emergency slush fund for any unexpected bills. Under no circumstances should you touch this account during the year unless absolutely necessary.  Your vacation to Naples IS NOT an emergency. If at the end of the year you have been disciplined and there’s a nice chunk of cash in the account, you have permission to use it as a bonus to yourself (woop!) or perhaps invest it for future you.  Remember to keep enough in there for a real emergency!
3. Taxes: If you are US based, consider 15-20%*. In Canada, it depends on your business structure.  If you are a sole proprietor, remember that as your income increases, your marginal tax rate will increase as well and you will need to set aside anywhere between 15-53% (Federal) AND 13% (HST / Provincial)*.  To get the exact percentage you should allocate, check out this calculator at SimpleTax.   
4. Operating Expenses: 40-60% . This is everything you need to run your business with.  Membership fees, conferences, bill payments, etc. If you find it a squeeze, run through your expenses and determine your needs vs wants.

For illustration purposes, let’s say you deposit a $10,000 cheque to your account.  Based on the allocations noted above, it will look like this:

Pay (20%): $2,000.00

Profit (3%) $300.00

Taxes (33%): $3,300

Operating Expenses (44%): $4,400

Creating a steady income for yourself can help reduce stress and keep your focus on building your business.  If you decide you need only $800 a week, your $2,000 Pay bucket will have $1,200.00 left to draw another $800 from the following week.  The goal is to make your income less sporadic, and more dependable.

If you don’t have enough to pay your expenses, you have two choices: increase your sales or reduce your expenses.  It sounds harsh, but when it boils down to it, there are no other choices.  You’re in business to make money, remember?

This method will take time to implement, but it’s important to stick to it.  Naturally, human behaviour will kick in and it’s easy to steal from one account to cover another (we’ve all been there!). To reduce temptation, consider transferring the taxes and profit accounts to another bank altogether.  The goal here is out of site, out of mind.  Just be mindful of the transfer fees at your bank, otherwise this method could become expensive. Good luck!

 

*Note that the tax bucket depends on how much you earn over the year and are guidelines only.

 

Stephanie Wolfe is a certified financial coach who lives in Toronto.  She is a passionate advocate for empowering women to attain financial independence and freedom through education and counselling.