Profit Allocation Plan – Week #49 of The Financial Operating System®
In the previous chapter, we explored the importance of adequate capitalization. This chapter introduces the concept of a Profit Allocation Plan as a structured approach to building capitalization and managing competing claims on profits. The goal is to balance financial stability, business growth, and owner rewards while minimizing financial risk.
Key Concepts
1. Purpose of a Profit Allocation Plan
- To ensure profits are used intentionally and strategically.
- To create a balance between taxes, building capital reserves, debt repayment, and owner distributions.
2. Components of a Profit Allocation Plan
Profits are divided into specific categories, with a percentage allocated to each:
- Taxes:
- Funds are set aside to cover business and pass-through owner tax obligations.
- Purpose: To avoid tax-related cash flow issues and ensure compliance.
- Debt Repayment:
- A fixed dollar amount to service existing debt.
- Any additional amounts to accelerate debt repayment.
- Purpose: To reduce financial risk and improve long-term financial health.
- Cash Operating Reserves:
- A portion of profits is allocated to build or maintain cash reserves.
- Target: 1-2 months of operating expenses.
- Purpose: To provide a financial buffer for working capital and contingencies.
- Investments:
- A share of profits is reinvested into the business to replace obsolete assets and for growth initiatives.
- Purpose: To ensure the business sustains itself and can grow.
- Owner Compensation/Distributions:
- Profits are distributed to owners after covering the prior 4 business needs.
- Purpose: To reward owners for their work and investment.
3. Example Profit Allocation Plan
While percentages may vary based on the business’s goals and stage, a typical breakdown might be:
- 40% for taxes
- 5% for debt reduction
- 30% for retained earnings to build capitalization
- 15% for investments (maintenance + growth)
- 10% for take-home distributions
4. Benefits of a Profit Allocation Plan
- Financial Stability:
- Ensures the business is prepared for unexpected challenges.
- Debt Reduction:
- Gradually lowers financial risk by systematically reducing debt.
- Sustainable Growth:
- Reinvestment supports innovation and scalability.
- Owner Rewards:
- Provides consistent compensation to owners.
- Tax Preparedness:
- Prevents surprises and ensures funds are available for tax payments.
5. Flexibility and Adjustments
- Businesses should adjust allocation percentages based on specific needs:
- Prioritize debt repayment when liabilities are high.
- Increase growth investments during expansion phases.
- Regular reviews of the plan help align allocations with evolving business priorities.
Example
A business earns $100,000 in profit for a quarter. Using a typical allocation:
- $40,000 is set aside for taxes
- $5,000 is allocated for debt repayment.
- $30,000 is dedicated to building cash reserve and equity
- $15,000 is reinvested into growth initiatives
- $10,000 is distributed to owners as take-home distributions
This systematic approach ensures all critical financial areas are addressed, fostering stability and growth.
Takeaway:
A Profit Allocation Plan provides a framework for managing business profits effectively. By balancing taxes, debt service, building capitalization, making investments, and rewarding owners, businesses can maintain financial health, support growth, and ensure long-term success.
Next Step:
Business owners can self-implement The Financial Operating System. Chapters are available to download at smartbooks.com/resources or you can buy the whole book from Amazon (the marketing firm version or the general business version).
If you would like assistance with implementation or would like to accelerate results for your business, please contact author Cal Wilder at cwilder@smartbooks.com or book a free consultation with our team directly using this calendar link.