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Paying Down Debt with Profit First

 

Profit First

The transition to Profit First can seem like a big adjustment when you’re paying down debt. Often, clients are so motivated as they start cutting costs that they apply all those savings to reducing debt. They are so excited about the progress that they bypass the profit account and apply all extra monies towards debt reduction. As much as I love moving towards freedom from debt, I suggest a different approach.

Why Use Profit First

The Profit account is your friend in implementing Profit First, and I don’t recommend bypassing it, even when you have a debt to eradicate. Here are a few reasons for using the Profit account, especially if you have debt in your business.

  • The Profit account is a multi-purpose account. The first purpose is to ensure that you are setting yourself up with a profitable business. You allocate to the Profit account first for each allocation. If you don’t have funds to allocate, then you have a problem with either pricing or your product costs, etc. Knowing this issue exists is critical to getting on the right path.
  • Allocating to the Profit account and taking profit distributions reinforces the correct behavior in your business. As you allocate the funds in this account, even if the majority ultimately goes to debt reduction, each quarter make sure that 5-10% of what you take out goes to reward yourself for this new behavior in your business. This reward is essential and should not be overlooked. Studies have shown that we are more likely to stick with a new routine if we are rewarded during the change process.
  • Another benefit of the Profit account is that you are building up a rainy-day fund. This rainy-day fund is what will allow you to weather the next crisis and not have to borrow funds to resolve it. You will become your bank, able to those weather storms. It’s a terrible feeling to pay off debt and then when the next storm arrives, and you must borrow again. Building your rainy-day fund will allow you to eliminate debt for the long term. Establishing this fund simultaneously as you pay down debt will provide some insurance that you don’t end up borrowing again. It does take a little longer to reduce the deficit, but it is helping you be more successful in the long term.
  • Use the majority of the Profit Distribution to pay down debt quarterly. If you have extra funds accumulating in your operating expense account during the month and you want to use that to reduce debt, excellent.

The Flow of Money

You’re adding to your Profit account twice a month with your allocations. Then each quarter, when you take your Profit Distribution, leave ½ of what you added during the quarter in the bank account. This method is building your rainy-day fund. Of the ½ that you take out, use the majority, 90 to 95%, to pay down your debt. The remaining 5 to 10% is your celebration money. It may be enough for a nice meal or a cup of coffee, or perhaps it’s enough for a gift. But take the time and energy to celebrate your success and reward yourself as a business owner! If you have a lot of debt, these small celebrations will help you stay the course.