Banks love to get businesses to use Overdrafts and Lines of Credit. Short of credit card lending, this is very lucrative for banks, but it traps business owners into easy debt that is hard to get out of.
One of the commitments that you made when you started with Profit First was No New Debt! Your next commitment was to get out of the debt that you already have (debt = jail). Overdrafts and LOCs are debt in the same way that a mortgage is debt – actually, it’s worse debt!
The problem with Overdrafts and LOCs is that you can (and the bank wants you to) keep drawing down on it. Every time you make a deposit you get more room to borrow money. You don’t feel like you’ve gone further into debt, but you have. It allows you to make decisions that you actually can’t afford – just because the bank lets you. That is no way to run a business!
One of the advantages of these accounts is that every deposit is like a small loan repayment that will reduce your balance and therefore reduce your interest cost. This is how banks sell you on these accounts. But they often carry a higher interest rate than other loans, so the overall cost may well be higher than you think.
So here’s what you MUST do if you want to successfully get out of debt when using overdraft or an LOC. Yes, this is a MUST, not an option. If you keep operating the accounts the way you always have you will never get out!
Convert the OD/LOC account to Debt and freeze it
You have to stop using these accounts as your main spending account. These accounts are debt and need to be treated as such. Talk to your bank about taking out a fixed term loan (at lower interest rates) and paying off the OD/LOC account. Don’t let the spin-masters convince you that the LOC is better than a traditional loan. It is – but only for them, not for you!
If getting a lower rate loan is not an option then we need to freeze this account. Simply stop using it to make any payments. Open another checking account to use as your spending account. You can continue to use the OD/LOC as your INCOME account only, but you need to be committed to transferring the allocations out every cycle. Yes, you will pay more interest, but you will be out of debt faster! Keeping the OD/LOC account as your income account will actually help you reduce interest as the daily deposit will be reducing the balance. Even though it will go back up again when you make your allocations, it will still reduce the interest compared to what you would have paid had we moved the income into another account all together.
Set up a Debt Allocation
You should set up a debt allocation as part of your Profit First process. If the OD/LOC is your only debt, then simply leave the debt allocation amount in the account (no need for a separate Debt Account) and every month your balance will get lower. If you have other debt then transfer the full debt allocation out, and then make a repayment back to the OD/LOC.
What is an Overdraft or Line of Credit Good for?
You should NEVER borrow for the general operations of your business. This is a sure sign that your business has cash flow issues or is not profitable. An Overdraft is really good on your spending account as insurance against an automated payment that you didn’t fund in time. Overdraft and LOC facilities are also very helpful as an emergency fund, especially in the early days of implementing Profit First when you haven’t had a chance to build up your profit vault. But beyond that they are a crutch that allows you to make bad decisions without immediate consequences and should be avoided.
Warning: Your financial advisors will probably try to convince you that this is crazy
The vast majority of accountants take one look at the Profit First methodology and say things like “that’s fine in theory, but it just doesn’t work in the real world.” They are stuck in the “Profit comes out last” mentality that is drilled into us with years of financial statement preparation. Like I was, they weren’t willing to look at the work from their client’s perspective and get creative with new ways of thinking that can actually change your business. Unfortunately most accountants just can’t make the switch. If your accountant challenges you on this, I recommend that you switch to a Profit First Professional. Even if you can implement Profit First without assistance, you want your Accountant and Bookkeeper to be supportive of your plans, not working against it.
Many bookkeepers look at the extra bank accounts and say things like “this will take me hours of extra work each month – it’s too expensive.” I’ve even heard of bookkeepers refusing to help! The truth is that implementing Profit First probably will result in some increased bookkeeping time – but only marginally. The extra bank accounts will require reconciling, but they will only have half a dozen transactions a month in them, so it’s not a lot of time. If you are using a cloud-based accounting system with bank feeds (such as Xero), this additional time is truly insignificant. And remember the reward – a more profitable business, paying you more and having money set aside for when it’s needed. So if you spend a few extra dollars each month in bookkeeping time, it’s worth it!
Your banker will try to convince you that you’ll pay more interest using this approach. You probably will. But ultimately you will make more profit and become debt free. Your banker likes keeping you in debt. He/She has different objectives – don’t let them run your business!
Need help implementing Profit First?
While the Profit First system is fairly straightforward, the hard part is changing your decision making process. At Fuel Accountants we’re experts in helping people implement Profit First and making their business more profitable.
