A recent study found that 23% of small business owners cite a lack of cash flow and overall capital as their number one challenge. These issues often prove decisive in the success of a startup. For example, a separate report determined that six out of 10 business failures can be blamed on cash flow problems.

How can you avoid this trap? How can you maintain positive cash flow and minimize the risks to your small business or startup?

The Profit First model offers an answer. This approach to your company's financial health puts profits and positive cash flow at the heart of the process. You make this crucial factor the primary consideration as you plan your operations.

This article takes a close look at this strategy. We'll explain how the Profit First method works for small businesses and how it can help your company overcome the potentially fatal risk that comes from constantly burning cash.

What is the Profit First method?

All entrepreneurs start their businesses to make money. They are driven by the profit motive. With visions of vast riches, they take the necessary risks and invest large amounts of their time and effort to push their ventures forward.

That's the theory anyway. In practice, many founders delay paying themselves or even securing a profit. They delay going into the black, focusing instead on overall growth and building their organizations.

This can be a mistake. Without profits, your business is on a clock. Burn cash fast enough and your endeavor (however promising) will collapse.

Without profits, your business is on a clock. Burn cash fast enough and your endeavor (however promising) will collapse.

There’s more. When you run at a loss, each passing day sees your resources diminish as your cash position dwindles. You become less flexible over time as your bank account shrinks. It gets difficult to capture opportunities when your books are splattered with red.

The Profit First method looks to avoid these traps. First described by author Mike Michalowicz, this strategy puts profits in the spotlight. Rather than pushing profitability into the hazy future, this approach calls for you to grab a profit from the first dollar of revenue you receive.

How does the Profit First method work?

To quote how Michalowicz put it in his book Profit First: "The Profit First method is a system in which business owners take a percentage from each sale as profit. The traditional profit formula deducts expenses from sales, leaving the remaining amount as profit."

In some ways, the Profit First method relies on a change of perspective. Taken in its most simplified form, the traditional view of profitability can be summed up in this formula:

Sales – Expenses = Profit

Think about what that means in terms of execution. You connect with customers and then use that cash to pay your expenses. Profit represents what's left over after you run your marketing, production, and sales operations. It becomes an afterthought — a happy result that may or may not happen, depending on the size of your sales and expenses.

The Profit First formula shifts this emphasis. In its basic form, it looks like this:

Sales – Profit = Expenses

You start by assuming a certain level of profitability. You take that money off the top. In this conception, think of your profit as your first expense — the most unavoidable amount you're going to extract from each sale.

Pros and cons of the Profit First method

Using the Profit First approach can provide an excellent framework for organizing your business. Doing so can bring significant upsides. However, the approach has its share of risks and potential pitfalls. To better understand if the system makes sense for you, here are some pros and cons to consider:

Benefits of the Profit First method

• Accentuates profits from the beginning: Your eventual goal is to make money. The Profit First method instills that mentality from the start.

• Lowers risk of failure: Why do businesses fail? Largely because they run out of money. The Profit First strategy forces you to avoid burning cash — meaning you keep (and grow) your emergency funds over time.

• Forces increased discipline: The focus on profitability keeps you on a narrow path. You need to closely watch every outflow to ensure that you can pay yourself first.

• Encourages quick market responses: Taking profits first means having a clear view of the market. You need to know what prices you can charge and what your expenses will be. As part of the overall discipline involved, you need to stay in close contact with economic forces impacting your business.

Disadvantages of the Profit First method

• Doesn't suit every situation: Not every business lends itself to a Profit First approach. Capital intensive businesses or ones with high fixed costs can be difficult to launch with black ink on the bottom line from day one.

• Is easier said than done: It's a fine notion: pay yourself first. In practice, though, it can get tricky. You'll need to keep some level of flexibility to steer your startup through a complex market environment.

• Can limit speed of expansion: Often, startups sacrifice profitability for revenue and/or user growth. If you focus on solidifying the bottom line, you might need to accept the tradeoff of a slower pace of expansion.

How to use the Profit First method

There are certain pillars of the Profit First method to understand as you look to roll it out at your company. So far, we've largely discussed the strategy in theoretical terms — as a framework for organizing your business operations. However, to put it into effect, you'll need a practical approach as well.

We'll touch on some of the details in a moment. As a start, realize that you'll need to take concrete steps to apply this Profit First principle to your startup. This includes the appropriate financial framework (including separate bank accounts for various tasks) and specific allocation targets (like the percentage of profit you plan to take off the top).

To get a more detailed idea of what we mean, here are some of the considerations to keep in mind as you look to use the Profit First method:

Plan for profits

The fundamental conception behind the Profit First method involves putting the bottom line at the center of your thoughts, even as you prepare to launch your next endeavor. That means careful planning. You'll need to be able to accurately predict revenue, subtract the appropriate profit, and then carefully budget your expenses from there.

How do you determine the appropriate profit? There are two key percentages to keep in mind:

• Current Allocation Percentages (CAPS): How you are currently splitting your incoming cash. The main categories of concern are profits, taxes, and operating expenses.

• Target Allocation Percentages (TAPS): How you'd like to be splitting your incoming cash — your ideal mix of profits, taxes, and operating expenses.

Broadly speaking, the Profit First method begins by determining your TAPS, based on the size of your company and the specific financial pressures (such as tax rate) that apply to your business. From there, determine your CAPS and look for ways to close the gap between the two.

Know your markets, so you can set optimal prices

Given the structure of the Profit First method, a lot rides on the size of your incoming revenues. You'll need enough incoming cash to cover your profits and the expenses required to run your operations. To make the right decisions about pricing and overall sales strategy, it's crucial that you understand your core market.

Conduct as much research as possible before you begin product design or marketing. This will give you the information you need to set a baseline revenue estimate. From there, you can consider the appropriate profit number to take off the top and know what you’ll have left over for costs.

Meticulously estimate your costs

Begin with your top-line estimate. Plan on grabbing profits next. The final stage of the strategy involves efficiently producing your offerings with the cash left over.

Here, more research is needed. You'll need to minimize your expenses as much as possible, while still satisfying your customers. Make this an ongoing endeavor. A fast-evolving economy means you'll need to adjust to changing costs over time.

Separate your money

Here, we get into the nitty-gritty. How do you apply a Profit First strategy in practice? Start with separate bank accounts.

Having a series of bank accounts for each stage of the process lets you keep your funds distinct. Revenue comes into one account. Then you direct cash into other ones based on:

• Profit

• Owner's pay

• Taxes

• Operating expenses

Map your cash flow journey

Now that you've created a banking structure to facilitate a Profit First approach, it's time to put the process into effect. You'll have the framework necessary to track the journey your cash takes through your organization. This will let you determine your TAPS, compile your CAPS, and give you the information necessary to optimize your product.

Using the Profit First method for your small business

The last several years have seen elevated inflation, rising employee costs, and the highest interest rates in decades. These challenges have made it difficult for small business owners to stay cash-flow positive. Given the difficult operating conditions, utilizing the Profit First method could prove helpful.

Use the details provided here to better understand the Profit First method for small businesses. With this information, you can begin to decide if this cash management strategy is right for your company.