If you're a business owner, I strongly urge you to budget for a reasonable profit target as a percent of sales, and then make your expenses fit in. The idea is to put profit front and center as a necessary outcome ... to make it happen on purpose, rather than let it happen by accident.
Now, let's build on that idea.
First, what is a reasonable target for profit before tax? It varies by industry but I suggest that most of us should be able to shoot for 10% of sales, pretax.
I can already hear howls of protest ...
Those who already earn more than 10% will of course say that it's too low. My response: Keep up the good work!
Others may think 10% is an unreachable goal, and the accepted wisdom in their industry backs this up. Fine, but don't stop trying to improve.
For now, I'll use 10% as a nice, round, healthy target. Let's say you have a business with $1 million in sales and pretax profit of 10%, or $100,000.
Well, for starters you'll be spending roughly a third on income taxes. Some of you may be higher and some lower, but that's an average. It's not pleasant, but it's like complaining about the weather. Let's get over it and talk about the other two thirds.
If your business carries debt, part of your profit will be used to service the principal, since unlike interest, it doesn't show up on your income statement. If it's at a high interest rate (like credit cards) you should either refinance at a lower rate or pay it down at an accelerated rate. Many of us borrow to buy vehicles or commercial real estate. In any event, in our example let's assume that no more than one third of our $100K profit is needed to make principal payments..
The final third.
This is the fun part, because you have options. You can ...
- leave it in the company to fund growth
- leave it in the company to create a rainy day fund
- use it to buy fixed assets
- take all or part of the final third as an owner distribution (Remember that pass-through entities will pay income tax on the profit whether you distribute it or leave it in the company.)
By the way, if you don't have debt these options are expanded to include the entire two thirds not needed for taxes.
Since profit and cash are not the same, you may have a profit on paper but little cash. Your cash may be tied up in inventory, fixed assets, principal payments or receivables. This reduces both your enthusiasm and your options, but it's an incentive to balance future efforts between driving profits and generating cash.
The lesson? Don't just plan to make a profit ... plan what to do with it. Do this planning well before year end with input from your tax accountant and make your business planning process inclusive.
This is the technical, geeky side of business ownership. Make this a core competency so you can have a healthy and sustainable company.
Bill Collier is the St. Louis area coach for The Great Game of Business. He helps businesses increase accountability and results with open-book management. He is the author of “How to Succeed as a Small Business Owner … and Still Have a Life” Bill can be reached at 314-221-8558 or firstname.lastname@example.org.