If you are like most craft-based entrepreneurs, the interest in your craft started as a hobby. Then through a series of thoughts, ideas, conversations, opportunities or some combination thereof your hobby became your business. Unfortunately, few of us (regardless of our previous experience) are truly prepared to handle all of aspects of this transition, particularly the challenges of cash flow.

Cash flow challenges

All small businesses, but particularly craft-based businesses often struggle with cash flow. The source of these struggles can be multifold:

• Insufficient start-up or growth capital
• Seasonality and/or inconsistency of income
• Overly tight profit margins

Now you may not think you are struggling with cash flow and if you aren’t congratulations! But often cash flow issues go unnoticed until it becomes a serious crisis. To see if your cash flow is solid, answer yes or no to the following statements:

1. I pay myself consistently at a level that is appropriate for the type of work I perform in the business and at a level equal to or above any other employees.
2. I have no business debt or if I do have debt, it is continually being reduced and never increases.
3. I have ample money set aside whenever it is needed to pay taxes, buy inventory, and cover expenses
4. I consistently take a profit distribution (separate from my pay) that is NOT reinvested in the business to pay back my initial investment and compensate me for taking the risk of being a business owner.
5. I am easily able to make informed decisions to grow, contract, or adjust my business based on real-time cash flow information.

The more yes answers to the above statements, the better your cash flow. However, even one “no” indicates that are opportunities to improve your cash flow through the use of a cash flow system.

A cash flow system

It is important to distinguish between a cash flow report and a cash flow system. A cash flow report if available at all, is generated by your accounting system or accountant, is based on the prior month’s numbers (not real-time), and is rarely useful to a small business. A cash flow system is a process that allows you to make informed decisions and dynamic adjustments based on what is happening in your business in near real-time.

Even as a business consultant with an extensive financial background, I hadn’t heard of a cash flow system until I stumbled across Profit First written by Mike Michalowicz. The Profit First concept takes the Generally Accepted Accounting Principle (GAAP) of “Income – Expense = Profit” and flips the formula around to “Income – Profit = Expense.”

This adjustment to the formula is significant because it changes the way we start to think about our business. Instead of waiting to see if we “made money”, we ask, based on our sales, can we afford a particular expense. Instead of spending money in hopes of making sales to cover the expense, we only spend money that we have already earned.

The method for this process is a simple allocation system based on percentages. If your parents or grandparents ever used an envelope system to budget their personal finances, the system is similar. The difference is it is designed for the dynamics of business and utilizes bank accounts instead of envelopes.

The power of the system is that it leverages your natural tendencies to manage your spending. Instead of having all your money in one big bucket (usually your business checking account), money is transferred into separate accounts designated for specific transactions. By doing so it becomes almost impossible to “accidentally” spend money that has been set aside for taxes or spend more on inventory than is prudent based on actual sales numbers.

In the process, it becomes easier to identify trends, positive and negative, within days or weeks instead of months and thus make appropriate adjustments faster.

How it works – a case study

The beauty of the Profit First system is it is designed to be a flexible tool, adjusting and changing as your business needs change. On a regular schedule, money coming in is allocated to various accounts (functional buckets of money) based on predetermined percentages. It is always recommended to have five basic accounts:

• Income – A holding account for all income deposits which is emptied at each allocation.
• Owner’s Comp – To ensure the owner (working in the business) is compensated as would any other employee.
• Tax – To consistently set aside money that will pay the business and/or owner’s tax liabilities.
• Profit – An account to ensure that owner is rewarded for taking the risk of starting a business regardless of whether or not they work “in” the business.
• OpEx – The business checking account to pay all other business expenses.

Although the basic system is designed for any type of business, it is also customizable.

In this client case study, the clients are a retail store with very seasonal sales based on tourist seasons, needing to reduce stock, and wanting to recoup the owners’ initial investment. As such, we made the following adjustments:

• Combined Owner’s Comp and Profit until the majority of the investment is repaid.
• Set aside a small percentage for additional debt reduction in addition to their regular monthly payment
• Added a Sales Tax account as a holding account for the sales tax collected for each purchase.
• Added a Slow Season Savings account to ensure the overages of the busy season were saved to cover the shortfalls in the OpEx account that happened during a slow season.
• Created an Inventory Purchase account that limited new inventory purchases based on the current balances in that account.

By setting up these accounts and making these changes the owners have not had to invest any more money into the business, but instead are recouping their investment. At the same time, they have reduced inventory, maintained sales volume, and paid all tax obligations without any stress or worry. But it didn’t happen overnight.

We started with a Profit First Assessment to determine what was currently happening in the business based on historical information. Then we discussed the goals and needs of the business and the best path for achieving those goals. Next, I developed a Strategic Implementation Plan suggesting small percentage adjustments each quarter to move relatively easily to the agreed-upon goals.

Although some clients like to take it from here on their own (a completely viable option), this particular client decided that ongoing support of the process made sense. So we meet on a regular basis creating accountability, tweaking the plan when necessary, and providing support for all aspects of their business.

Assuming their plan continues to stay on track, in just under two years they will be completely debt-free including paying themselves back their initial 6-figure investment. Their investment in implementing a cash flow system hasn’t been a quick fix, but it has created enormous compounding benefits they will continue to reap over the life of their business. If you want to keep more of the cash your business generates, a cash flow system may be the right answer for you too.