“Profit First” is a hugely popular financial management system and book written by Mike Michalowicz.
I’m not going to go into too much detail about the system here as there are plenty of other articles about it on the internet. You can find a good summary from one of our tech partners, Relay, here.
For a small business with a simple model – e.g. a sole proprietor, a consultant, a single store retail or a freelance gig worker – Profit First can be a really good solution for budgeting your cash.
It provides a disciplined approach to divvying up the revenue. It’s a lot like the envelope system for managing a household budget.
It claims to be a paradigm shift in how to look at revenue:
From Sales Revenue – Expenses = Profit
To Sales Revenue – Profit = Expenses
And by virtue of this formula, it ensures the business is always “profitable” and you won’t over spend.
What it doesn’t do is take the long term growth of your business into consideration
The Profit First method is a way of managing sales revenue after it has been received. However, if there isn’t enough revenue to cover basic expenses, it raises a question: should you still prioritize taking profits or use the funds for necessary operations?
While Profit First helps track incoming money effectively, it doesn’t offer insights on business profitability compared to industry benchmarks or guide you on the optimal allocation of your next dollar.
Now for some small businesses that’s fine. They want to stay small.
But if you want to grow your business, scale up, hire employees, or expand your operational footprint, you’re going to need a more mature and high-powered strategic accounting solution.
Michalowicz’s method assumes that entrepreneurs are like kids in a candy store. They can’t be disciplined and are incapable of long term decision making.
In my career working with hundreds of entrepreneurs, I’ve come to understand that the most successful operators are risk takers who possess a long-term vision they relentlessly pursue through strategic planning and unwavering discipline. While Profit First serves as a solution for cash management today, it fails to contribute toward long-term growth.
Here are 4 signs you’re ready to upgrade from Profit First:
1. Your business hits $1M in revenue or is on a high growth trajectory.
Did you know that 94% of small businesses will never make it past $1M in annual revenue? Crazy right. So it makes sense that Profit First alone works for a lot of small businesses; most are pretty simple.
Reaching the $1M mark brings increased complexity. Hiring becomes necessary to meet growing demand, but it requires careful consideration of metrics to determine the right timing and quantity of hires while managing margins effectively.
As a CEO, having immediate access to financial data is crucial for informed decision-making. Metrics like margin trend lines, which Profit First lacks, are derived from accrual-based financial statements using GAAP (Generally Accepted Accounting Principles). These statements help owners identify operational issues and are the foundation for providing forward-looking insights.
CEOs empowered with this information make faster, better decisions, improving business outcomes as they scale their company.
Example:
We had a client who was using Profit First to run their business. They had no financial statements.
They hired us to fix their accounting function. After we put together their financials on an accrual basis, we noticed that their health insurance expense as a % of labor was increasing over time.
After investigating further, we found out that they were not removing employees from the health insurance policy upon departure from the company. Over the last two years they had paid out $270K in health insurance for employees who no longer worked for them. This was one of many operational issues we discovered simply by putting together a proper set of GAAP financials.
2. You need a loan, investment, or want to sell your business
Michalowicz might think GAAP is wack, but there’s a reason they call accounting the language of business. Profit First is a cash-management system and while it helps you become intimately familiar with the ebbs and flows of cash in your business, no third party is going to take you seriously or hand over their money to you if you don’t have real financial statements.
An investor is going to want to quickly see if the business has sustainable and consistent profit margins. They want to see GAAP financial statements so they can compare your company to others in the same industry–apples to apples.
When you sell your business, typically buyers will want to see at least three years of GAAP financials.
When you go to get a line of credit (and by the way, your business should have a line of credit for emergencies, even if you never use it), the bank is going to want a proper set of accrual financial statements. Without this, good luck getting those funds.
Example:
We once had a new client who wanted to sell their business. Although multiple potential buyers showed interest, the deal consistently fell through when it came to sharing financial data.
We ended up doing a huge project and putting together 3 years of historical financials for them. Long story short, we not only helped them successfully sell their businesses for multiple millions, we uncovered some other issues that could have been caught several years prior. For example, one of their employees had been stealing from them for years by using the company credit card for personal expenses. Because they did not have a proper accounting function/oversight/controls, they completely missed this fraudulent activity, and it cost them hundreds of thousands of dollars.
3. You’re making too many short-term decisions in order to make it work.
So what happens if your revenue is down for a couple months? The Profit First Method is very strict and says you may NOT use other money to cover expenses. You’re forced to reduce your costs and find a way to pay what you owe when the next allocation to your operating budget comes in.
So, if you follow Profit First, that means you’ll probably have to lay people off. That will reduce expenses, but that’s costly in other ways. You invested in those employees. Trained them. They may have relationships with your clients. But you have to make your profit, right?
The reality is you’re not going to lay them off, nor should you. You’re going to take the hit for a couple months and go out and get more business.
You can’t let a cash-management formula leave you short sighted. Business is a long term game.
Example:
I personally had this happen where we lost about 25% of our revenue that was wrapped up with one client who sold their business.
After this client dropped off, my business was operating at break even. Yes it was incredibly depressing for a hot minute there, but there was no way I was about to let go of any of my employees. I know how valuable great employees are, having invested years into their training and guidance. Instead of panicking and cutting staff, I went out and drummed up more business. I was back to normal profitability in a few months. You see, each hour and each dollar you put into your business should be thought of as a long term investment.
I was able to quickly put together a forecast and knew I was going to be okay if I just closed 5 more clients at $x revenue per client over the next three months. If you have a good advisor who can help you understand your financial situation when things like these happen, you will not be flying blind or making decisions based on gut reactions.
4. You have better things to do than move money around.
The Profit First method is time-consuming, unrewarding, administrative work. That’s time that you’re not spending making sales and growing the business. It’s probably holding you back more than you think.
In the Profit First book, the author says “when in doubt open another bank account.” I had to roll my eyes when I read this. We often get prospects coming to us and we can tell they’ve tried Profit First because they have 15 different open (but not active) bank accounts. I like to refer to this as “the Profit First graveyard”. The system takes a lot of time to maintain and as a result many people will discontinue its use after some time.
Today, the right combination of people and software can take all of that administrative work off your plate and free you to be the business-building dynamo you are.
Example:
We had a client who’d been in business for seven years and could not grow the business beyond himself.
He would hire someone and then quickly let them go when his cash balance started going down (due to following Profit First). He was constantly worried about cutting a $20 subscription here, getting a discount there. He was trying to do everything on his own rather than investing in advisors or coaching.
When we came to Momentum and we did our initial discovery, we were able to quickly identify that he needed to triple his pricing in order for him to scale his business profitably.
Because he was so expense focused due to following Profit First, he did not want to invest in professional help. We could have saved him several years of hardship if he made the investment in our team sooner.
Want to see what a cloud-based strategic accounting system can do for your next stage of growth?
The fact is, with the right tech-stack and the right accounting advisors, you can have a world-class cloud accounting system that blows Profit First away. In our world, accounts payable, accounts receivable, payroll, are all highly automated and integrated to accelerate cash-flow, simplify collecting money from customers, and give you real-time status on your financial performance. Plus you will gain actionable insights and get smarter every month through our reporting and advisory services.
Profit First is conservative, backward looking, and focuses solely on allocating money you have already made. In contrast,
our system prioritizes growth and maximizing the return on investment for every dollar you plan to spend. It’s for savvy business owners who have their eye on the long game.
If you’re ready, schedule a no-obligation discovery call with Ashley here.
