2 Common Money Mistakes That Drain Your Business Profits—and How to Fix Them

This article was originally written for my column for Inc.

If you’re like most small business owners, you spent the time and effort establishing, growing, and maintaining your company with an eye toward one specific goal — turning a profit. But all too often, small businesses never consistently get there.

While every company faces different circumstances and challenges, a close look frequently reveals two common factors holding businesses back: management payroll and distributions.

1. Management Payroll

To understand the true problem behind management payroll, it’s vital to take a step back and analyze a piece of advice business owners hear all of the time: “Work on your business, not in it.”  

The advice suggests that business owners need to spend less time doing the actual day-to-day work of the business, and more time managing the business, doing things like:  

• Optimizing processes

• Developing marketing and sales strategies

• Hiring employees

Having time to think at the strategic level is vital to growth, but unfortunately, many small business owners approach this too radically. 

At a2 advisers, we suggest clients consider it a dial instead of an on-off switch. Focus on slowly cranking up the dial toward spending more time working on your business, rather than only working on it when you feel overwhelmed with the day-to-day. 

When business owners stick to the latter, it often causes them to jump the gun with hiring. This mistake eventually turns into the business’s largest expense and one of the toughest to cut. 

Instead of letting employees go, some owners will try to grow their payroll by making it a goal to generate additional sales to cover the cost of wages. However, this tactic is incredibly difficult.

Generally, a business needs $5 or more in sales to cover every dollar of management salaries. For example, a manager making $60,000 annually will need $300,000 in additional sales to break even at a 20 percent gross margin. Without exponential business growth, reaching that threshold will be a major challenge. 

Digging yourself out of a labor-cost hole isn’t impossible, but you’ll have to make tough decisions along the way. Avoid this roadblock, chat with an accountant before hiring, and remember, most small businesses don’t require a suite-level full-time management anyway. 

2. Distributions

Even if they know better, too many entrepreneurs use their company as a personal bank account. This is a significant error that should be avoided at all costs. Taking too much cash out of the company in distributions robs it of its current and future profitability. The business needs that cash to grow.

When a business owner does take out too much in distributions, it leaves the business no choice but to rely on banks for financing. With current interest rates, this decision could result in a massive hit to the company. 

Finally, let me paint a picture of a situation where business owners taking too much in distributions led to legal action:

I worked at a CPA firm that had a turnaround service line. Essentially, a bank or court would assign the turnaround team to a business that was going under. In one case, their course of action was to sue the company’s former owners for taking too much money out of their own business. 

When and how to take the right amount of distributions.

To continue to grow, avoid high-interest rates, and avoid potential legal action, you have to take the appropriate amount of money out of your business. Do this by paying yourself a fair wage as part of your regular payroll. Otherwise, you could find your business under an Internal Revenue Service microscope, as structuring owner compensation as mostly distributions with little or no salary is one of the most common items the IRS will be looking for as it ramp up audits with its additional work force.

Finally, owners should seek to build up a cash reserve of at least one month’s operating expenses at first, growing this to two month’s worth over time. With the company finances on solid footing, it’s safe to take distributions.

When taking distributions, companies should follow financial expert Greg Crabtree‘s 40/30/30 rule, which splits all business profits into 40 percent for taxes, 30 percent toward business growth, and 30 percent for distributions. Another method, I use at a2 is Profit First target allocations. These methods will help owners safely enjoy their profits without worrying about jeopardizing their business in the future.

Ready for your small business to be more profitable?

There’s no doubt all business owners would love to see more profits, more growth, and more stability. But unless they eliminate these two common mistakes, it will be tough to achieve these goals. 

While it can be tempting to hire managers too soon to get you out of working “in” your business, fully consider the financial repercussions of this move — especially if you’re unwilling to potentially cut employees in the future. In addition, distributions need to be carefully managed to balance responsibilities, growth goals, and guilt-free profits for owners.

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