The Five Forces of Cash Flow: How to Allocate Your Profits Wisely
For businesses, managing cash flow wisely is crucial for ensuring long-term sustainability and growth. Profit allocation is a strategic process that must be approached with a clear understanding of priorities. Here, we will explore how to allocate your profits in a disciplined order: paying taxes, repaying debt, reaching core capital targets, and making distributions. This sequence helps maintain financial health and regulatory compliance, while also supporting growth and rewarding stakeholders.
1. Paying Taxes
First Priority: Taxes must be paid first. This is non-negotiable as failing to adequately allocate funds for taxes can lead to legal penalties and significant financial distress.
Strategy: Engage in proactive tax planning to understand how much you will owe in tax. Then make sure to set aside this money each and every month so that you are prepared to make the payments when they are due. Your advisor may recommend not paying taxes until you absolutely have to but you should be making sure you have this money set aside first before you look at spending money on other items.
2. Repaying Debt
Second Priority: Once taxes are accounted for, the next priority is to reduce debt. When we think about debt we categorize it into two different buckets. Term debt, which is debt that is to be repaid over a period of time with a set payment amount, and line of credit debt that is designed to be a cushion to help you through temporary operating constraints. Prioritize line of credit repayment.
Strategy: After your taxes are paid, line of credit debt should be paid off. This allows you to rebuild your safety net in the business so you can weather any other operational constraints or interruptions. Make sure you are not funding distributions on your line of credit or via term debt. Term debt should be used to fund major investments that will drive profitability in the future and allow you to pay that term debt.
3. Building Your Cash Reserve or Core Capital Target
Third Priority: After managing taxes and debts, focus on securing your business’s financial future by building up a cash reserve or meeting your core capital targets. This ensures you have a safety net for unexpected downturns and financial challenges.
Strategy: Determine an appropriate level for your cash reserves. This is dependent on the business but is typically 3-6 months’ worth of operating expenses. We used to recommend 2 months but as the economy has gotten less predictable we have increased the target for many of our businesses. Your focus should be on building this cash reserve once you have paid your taxes and your line of credits.
4. Growth or Launch Capital
Fourth Priority: After addressing taxes, debts and reserves you can start allocating capital to those growth initiatives that you have.
Strategy: As part of your strategic planning determine your growth initiatives and how much it is going to cost to get them off the ground and what the return on that investment will be. Now that you know the amount of capital you need, build a plan for funding that before distributions. This may take several years to fund your initiative if you want cash left over for distributions or the stakeholders may leave cash available for distributions.
5. Distributions
Fifth Priority: Only after addressing taxes, debts, reserves, and launch capital should profits be distributed to shareholders or owners. This ensures that distributions do not compromise the operational and financial stability of the business.
Strategy: Establish a distribution policy that is sustainable and aligns with the long-term goals of the business. Consider linking distribution levels to profitability, ensuring that the business retains sufficient earnings to support ongoing operations and future growth initiatives. Too often, we see business owners saying they need distributions to live on and prioritizing that to the detriment of the business. If you are paying yourself a reasonable salary and need distributions to live on then you have a lifestyle problem not a business problem. You should not be causing the business to suffer due to this and it is why a Holistic Advisory plan that aligns the business and personal goals is so important.
Integrating the Profit Allocation Strategy
Managing these priorities requires a balanced approach:
Financial Planning: Regular, detailed financial planning sessions are essential to ensure that profit allocation adheres to these priorities while supporting business goals.
Communication: Clearly communicate your profit allocation strategy to all stakeholders, including shareholders, employees, and creditors. This builds trust and aligns expectations.
Monitoring and Adjustment: Continuously monitor your financial performance and adjust your allocation strategies as needed to respond to changing financial circumstances and business objectives.
Allocating profits in the order of taxes, debt repayment, building reserves, growth capital and making distributions creates a robust framework for financial management. This strategy not only ensures compliance and stability but also supports sustainable growth and shareholder satisfaction. By adhering to this disciplined approach, businesses can enhance their financial health and position themselves for long-term success. If you need help realigning your profit allocation please reach out to us today.