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:
�
Taxes �
You must either set aside money or pay chunks of taxes as you go
along, to avoid the April surprise (or October surprise if you
extend how long you stick your head in the sand).
�
Debt �
Lines of credit are crack cocaine for entrepreneurs. Get off the
drug as soon as you can.
�
Core Capital �
Retain after-tax profits until you reach your core capital target,
which is generally defined as two-months of operating costs in cash
with nothing drawn on the line of credit and your anticipated taxes
set aside.
�
Distributions �
Reap your reward and finally take after tax profits to diversify
your wealth outside of the business.
Taxes:
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.
Debt:
Poor management of debt has killed many good businesses. It is like
a drug in that it allows you to postpone the hard decisions 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.
Core Capital:
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.
Distributions:
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 (not
consume) your wealth. 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 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 flow healthy for years to come.
Greg Crabtree has worked in the financial industry for more than
thirty years and founded Crabtree, Rowe & Berger, a CPA firm
dedicated to helping entrepreneurs build their business. He is the
author of �Simple Numbers, Straight Talk, Big Profits!�
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