Philip Campbell's Blog

Paying $250,000 in Income Taxes is a Badge of Honor

Have you paid $250,000 in income taxes in any single year?

Yes? Then CONGRATULATIONS. You are making great money in your business. You are on your way to creating wealth. You are on your way to developing the freedom that a strong net worth can breathe into your life.

The Numbers

If you have a business that is a pass through entity for tax purposes (S corporation, LLC, etc.) and your taxable income from the business is in the $650,000 range, then you are going to pay something like $250,000 in income taxes.

Lots of people think that's bad. They say, "Surely there is a way to lower that 'huge tax hit' I am having to take".

But that way of thinking is one of the primary reasons so few business ever make any serious money. They mistakenly believe that their objective is to reduce their income taxes. It's not.

The objective is to increase your income.

And when you are successful at increasing your income (by making more money) you pay more in income taxes. That's how business works.

Is Your AGI Growing?

Take a look at your personal tax return (Form 1040) for the last three years. Write down your Adjusted Gross Income (AGI) from line 37. Then ask yourself:

"What would it take to increase my AGI next year by 50%"?

For most business owners, the best way to increase their personal AGI is for their business to become more profitable. (Remember, I am assuming your business is a pass through entity for tax purposes.)

Consider spending more of your time in business focused on becoming more profitable. Setting targets for increasing your AGI is a great way to start.

That's how you create financial health, wealth and freedom. J

 

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Dilbert Loves Accounting

 

I've always been a fan of the Dilbert comic series. Business humor is the best. J

Scott Adams is the creator of Dilbert. I listened to a great interview recently with Scott on the Tim Ferris Show (Tim's podcast). Here is the link to that podcast.

Scott is a funny guy and he has some great tips and stories to tell about his rise to fame and his insights on business.

His book How to Fail at Almost Everything and Still Win Big is both interesting and funny. I especially love a short section in the book on Accounting. Here are a few quotes from that section:

"I found accounting nearly impossible to learn because of the bubbling moat of boredom that surrounds the entire field.

But a basic understanding of accounting is necessary to be a fully effective adult in a modern society, even if you never do any actual accounting on your own.

… Accounting is part of the vocabulary of business, and if you don't understand it on a concept level, the world will be a confusing place.

… You can pay others to do your accounting and cash-flow projections, but that only works if you can check their work in a meaningful way. The smarter play is to learn enough about accounting and spreadsheets that you understand the basics."

His statement that you need to know enough to understand the basics (of accounting and financial statements) is a very important point.

Cash Flow is a Great Starting Point

What's more basic then understanding the cash flow of your business?

You understand your cash flow when you can explain what happened to the cash last month in a 2-minute conversation.

It's easier than it sounds.

Here's a link to a pre-recorded webinar and Quick Start Guide that will show you how.

It's free.

 

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Your 5-Minute Profitability Assessment

What percent of your company's revenues should you be bringing to the bottom line? 2%? 10%? 20%?

Are you happy with your current profitability?

Those are important questions to answer because profit is the number one generator of cash flow. And cash flow is the number one creator of a strong net worth for business owners. (And building a strong net worth personally, and in your business, is your ultimate financial goal. Not to mention that being profitable is fun all by itself.)

Today I want to share a 5-minute process to help you answer those two very important financial questions. The goal of this 5-minute process is to come up with an estimate of what your annual profit should be (or could be).

Your estimate doesn't have to be right. It just needs to be a number you can write down. You will have plenty of time later to explore your estimate in more detail to determine if it should become your new profitability target.

The 5-Minute Exercise

Here's the exercise. You have 5 minutes to come up with an estimate of how much money you should make each year in your business. Here are the steps:

• Look at your pre-tax income (your profit before income taxes) for the last twelve months. Divide that number by your revenues (total sales). Jot that percentage down. Let's say that revenues are $10,000,000 and pre-tax profit is $500,000. So the percentage is 5%.
• Look at your gross margin (gross profit dollars divided by revenues). Use that percentage to lookup your pre-tax profit target range in the chart below. Let's say gross profit is $4,200,000. So the gross margin is 42%. The pre-tax profit range in the table is 15% to 20% of revenues.

• Pick a pre-tax profit percentage in the range and multiply that times revenues. Write that number down. In my example, I'll choose 15% (to be conservative). That number times $10,000,000 in revenues is a pre-tax profit target of $1,500,000.

In that exercise, based on my example, the profit target is $1,500,000 and the actual profit is $500,000. The Profitability Gap is the difference, or $1,000,000.

Remember, it's just an estimate… for now. You will have time to more fully analyze that number later.

You should be able to come up with an estimate for your company in 5 minutes or less. Try it.

But Philip, What About…

I know. I know. You have questions. J

Where did those target percentages come from? Did you pull them out of thin air?

Fortunately we have lots of great examples of companies operating in those profit ranges (and even higher).

I'll talk more about that (and this exercise in general) in upcoming posts.

 

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Your Mission as a Serious-Minded Entrepreneur or CEO

Your mission (and challenge) in business can be simply stated as:

Getting and Keeping Customers… Profitably.

 

Peter Drucker said it this way:

"The purpose of business is to create and keep a customer."

Your Customer Factory

I like to look at a business as having two parts – two "factories".

The first part is your Customer Factory (see the graphic above – special thanks to Ash Maurya, author of the book Running Lean: Iterate from Plan A to a Plan That Works).

The mission of your customer factory is to create happy customers. And do it profitably.

That's where the serious-minded entrepreneur or CEO shines. You know it all starts with the customer and the customer experience.

Creating repeat customers is the essence of business. Turning customers into raving fans who preach the word about your business to their friends and colleagues creates an unstoppable customer generating machine.

You also know the role of money in creating a successful business. Getting and keeping customers profitably makes it possible to achieve your ultimate financial goal in business:

Creating Wealth for the Owners of the Company

 

I am defining wealth here as having a strong net worth (both in the business and for each of its owners).

It flows like this: Profitability – Cash Flow – Net Worth.

Profitability generates cash flow. Managing your cash flow wisely creates a strong net worth (wealth) for the owners of the business. Here is a visual representation of how the three financial components work together to create financial success:

 

Your Money Factory

The second part of your business is the Money Factory. This is the part of your business whose goal is creating wealth for the owners of the business. It looks like this:

Profitability is the primary driver of cash flow over the long term. Then wise financial management of all the different drivers of cash flow (in addition to profitability) positions you to create happy owners (by helping them create a strong net worth).

A happy owner is one who knows the business is strong financially, sees the value of the business continuing to increase, understands that a portion of the cash flow should be reinvested in the business so it can grow, and enjoys receiving cash distributions that represent a healthy return on their investment.

The Role of a Seasoned CFO

A seasoned CFO knows that your Money Factory must be managed strategically. You need a process, a system, for managing all the different components of what it takes to create a company that is strong financially.

The 10-step process (click here), or roadmap, provides the achievable, step-by-step process for making your company stronger every month. (Click here to read a more detailed description of the 10-step process in an article I wrote for the Business Bank of Texas here in Austin.)

The Monthly Financial Rhythm (click here) is the overall system, or framework, I use for implementing the 10-step process. Its larger purpose is to help you build a Money Factory that creates wealth for owners. Its mission is to help you win financially in business.

Both Factories Are Important

Your Customer Factory and your Money Factory both need to be humming along nicely in order to achieve your two highest priorities in business:

1. Getting and keeping customers… profitably
2. Creating wealth for owners

Take a minute to evaluate how you are doing in each area.

On a scale of 1 to 10, where 1 is horrible and 10 is awesome, rate how well your business is doing on each priority.

Your rating will tell you where you need to invest your time and attention.

 

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