4 types of profit every business owner should track

Starting a business is really hard. It’s no surprise that 49.7% of businesses fail in the first 5 years (link).

And the #1 reason for failure is cash flow issues (38%, per Lending Tree).

Now, running out of cash is actually the result of other problems… not enough sales, too much spending, funding not coming through, etc. But that doesn’t change that it’s a major issue.

So, how can a business owner get better at managing their cash?

In my latest podcast episode, Josh Patrick talked about the concept of splitting profits into 4 categories:

  1. Good lifestyle
  2. Emergency fund
  3. Business growth
  4. Retirement funding

Good lifestyle

Too many small business owners forego a salary to make their startup work. It’s actually seen as a point of pride.

I understand why this is done. You want to give your business a chance to succeed. You want to feed your employees first. But, you’re not valuing yourself. Sure, there may be a period at the start where you don’t take a salary. Over time, the salary allotted to you, as the business owner, should go up to market value. If your salary isn’t market value and your profits are low, you’re not actually that profitable.

It’s easy to trick yourself into thinking you’re profitable when you’re not. When your salary isn’t market value, you do just that. You become comfortable with the status quo and then next thing you know you’re trying to sell the business (we’ll talk about that later) and you’ve squeezed margins too much.

I have seen a bit of shift away from this mindset lately, which is a great thing. Hopefully, we’ll continue to see this mindset shift. You don’t get into business on your own to scrape by… you get into business for yourself because of the possible upside. Take some of that now and work on improving your business along the way.

Emergency fund

Just like in your personal finances, businesses should have an emergency fund. Josh recommends 6-12 months so that the business can weather almost any storm.

This goes back to running out of cash. Too many business owners don’t keep enough cash on hand, which means that when hard times hit they’re immediately in a cash crunch.

Hard times could be:

  • an economic downturn
  • an unexpected expense
  • a big client not paying on time

The 6-12 month cushion gives you the breathing room to make level-headed decisions and not have to act rashly at the first bump in the road.

Business growth

It may seem that growth is always good, but I can assure you that’s not the case. If growth happens too quickly, you won’t be able to afford the growth. What do I mean?

Let’s say you get a new client. That client wants 5x your annual revenue in one order. How do you fund that order? It’s unlikely you have the cash, so you have to go to your suppliers and ask for special terms. If they don’t provide them, you might be out of luck.

But say you can afford them… and I use “can” loosely. Now, you pay for the product today (7/28/2022), but you likely won’t get paid from the customer until 30-60 days down the line. Sure you had a cash reserve, but that reserve is now GONE with one order.

With one unexpected expense, you could be out of business.

This is why forecast are extremely important. It tells you what cash you may need in the future so you can make the plan for it today. Maybe you hold back cash to protect yourself. Maybe you start seeking funding (ahead of when you need it). Maybe you try and renegotiate contract terms (with suppliers and/or customers).

Understanding your growth trajectory and the cash needed is an essential part of being a business owner.

Retirement funding

So many business owners just work, work, work. They jump from one problem to the next without ever thinking about the future. What happens if you have an injury? What happens if you can no longer work? Or no longer want to work?

Many business owners assume that when they get to the end of the road, there will be someone to sell it to. Maybe it’s internal, maybe external, but very few actually do the proper planning for this exit.

So, what happens? They end up stuck with the business or only able to sell it for a steep discount. I’ve seen this situation first hand. The business owner didn’t plan for retirement… his company was his retirement plan. When it came time, he was unable to get what he needed and thus stuck with his business.

So, whether the plan is selling the company or winding it down, every business owner needs to think about how they’ll make money after the business. Examples would be:

  • traditional retirement accounts
  • selling the business
  • real estate

But, no matter your plan, it’s best to have contingencies and put your eggs in multiple baskets.

Thinking in terms of these 4 types of profit completely changes the way you operate your business.

This also applies to personal finance. Pay yourself first, get an emergency fund, create an FU fund (buffer so you can quit your job to chase a dream), and plan for retirement.

Hopefully this was a helpful thought exercise that helps you think differently about your profits (and salary).

To hear the discussion with Josh Patrick on this, business dashboards, and creating a sustainable business, listen to the podcast:

Frameworks & Finance
Frameworks & Finance
4 types of profit every business owner should track

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2 comments on “4 types of profit every business owner should track
  1. Edward Ogbebo says:

    1 want to purchase the Financial statements decoded ebook

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