How Much Should You Pay Yourself as a Small Business Owner
Many small business owners face the dilemma of taking money out of their company to pay themselves or leaving it for future growth. The free-cash-flow method helps you do both.
Many small business entrepreneurs struggle with the question of how much they should pay themselves.
Some entrepreneurs only look at their checking account balance to determine how much they can take out. If the account has a high balance, they believe it is available for them to withdraw, only to find out later that they would have needed the money to pay a supplier. They often have no choice but to deposit the cash right back into their business by writing a personal check or using a personal credit card.
Those entrepreneurs who have gone through these fire drills before know the question isn’t how much money you can take out from your company to pay yourself but how much money you can safely take out while still meeting your business goals?
Your Company Is Separate From You and Has Its Own Goals
Regardless of how the IRS treats your business for tax purposes or what legal structure you have chosen, I recommend thinking of your venture as its own separate entity that pursues its own goals.
These goals can be many.
You might want your company to grow in a specific region or timeframe. If you run a not-for-profit, your business might focus more on social and less on monetary objectives.
Whatever these goals are, they are specific to your company, not you personally.
Your Business Requires Cash to Operate and Achieve Its Goals
Whether your business is for-profit or not-for-profit, it requires cash to operate and achieve its goals.
Usually, in a for-profit scenario, this money comes from your customers in exchange for delivering a product or service.
If the money received is higher than the cost of providing the product or service and running your business, your company will make a profit and earn excess cash.
You decide what to do with this cash. You can take it out or leave it in the company.
Often these two options pose a dilemma because the more money you withdraw to pay yourself, the less is available to fund your business objectives.
Establishing an order of precedence can help solve this dilemma.
Distribute Only the Cash Your Business Doesn't Need
Since your company has earned the cash by selling products or services, it belongs to your business. It doesn't matter if you, as the owner, can decide what to do with the money. This decision comes second.
First, the cash stays in the company, and the funds are used to keep it running and, additionally, to pay for investments required to achieve its goals.
Second, only the money that isn't needed by your business is available to be distributed.
This excess cash is called free cash flow. It is the amount of money that is left over after paying for your company's ongoing operations (cash from operations) and investments (capital expenditures).
How to Calculate the Amount of Money You Can Safely Take Out to Pay Yourself
The free-cash-flow concept requires you to know your monthly profit and investment plans. There is no way around it. But that alone won't be enough.
Since most small businesses follow the cash-based accounting method, you should also keep track of all unpaid customer invoices and upcoming one-off supplier payments, such as annual subscription renewals or inventory purchases.
With this information at hand, you can follow this simple formula:
CASH-BASED ACCOUNTING METHOD: Prior Month Profit ± Cash in Transit (1) - Est. One-Off Expenses - Est. Capital Expenditures = Est. Cash Available for Distribution ACCRUAL-BASED ACCOUNTING METHOD: Prior Month Profit - Increase in Accounts Receivable + Decrease in Accounts Receivable ± Cash in Transit (1) - Est. One-Off Expenses - Est. Capital Expenditures = Est. Cash Available for Distribution (1) Cash in Transit is money being transferred by a payment processor (credit card company).
Even if your payment forecast is detailed, always leave yourself a cushion to deal with the unexpected.
A renewal invoice for a subscription you had forgotten or a special discount a supplier offers you for placing a larger order.
If you have some money set aside, you won't run into a cash crunch, but you can still benefit from a discount opportunity.
