The key to determining savings amounts for savings goals is the length of time available for saving. Time value of money can be a very strong participant in meeting financial goals. Understanding Profit First is the first step but here you will learn exactly how to implement it. Show notes and links can be found at http://DreamBuilderFinancial.com/1007.
In the personal finance section this week, we’re going to talk about how to look at goals, and how to look at the logic behind setting savings amounts for the goals. We won’t get into specific numbers or calculations for how to do this for yourself yet, but rather will look at the concepts behind the big picture.
The time value of money is what happens over the course of time if you put money to work for you, and its basis is compounding interest. Also, there are two factors that affect the growth of money: the rate of return, and the length of time available. I explain all of this in the podcast, but I’ll write out an example of how compounding interest works in case you’re more of a visual learner.
Compounding Interest Example:
Let’s say you start with $100, and you can earn 10% interest or return over the course of a year.
At the end of a year, you’ve earned $10 (10% of $100).
Without compounding interest, at the end of 10 years, you’ll have earned $100 ($10 per year times 10 years). Your account balance will be $200.
With compounding interest, you earn interest on the amount in your account at the beginning of each year. Since you started year 2 with $110 in the bank (the initial $100 plus the $10 interest you earned), you’ll earn $11 that year, bringing your balance to $121.
The next year, you’ll earn $12 dollars, bringing your balance to $133. In year three, you’ll earn $13 dollars, bringing your balance to $146.
By the end of the ten-year example, with compounding interest, you’ll have $259. After 40 years, it would turn into $4,526.
In the business section, we move onto part 2 of implementing profit-first in your business. We’ll cover the how-to in this episode, but for much more detail, get a copy of Profit First by Mike Michalowicz.
Implementing profit-first methodology is a five-step process, which I discuss in the podcast. For easy reference, here are the five steps:
- Get crystal clear on your motivation for implementing this system.
- Open a separate bank account and immediately deposit 1% of your business’ cash into this account. This is now your profit account.
- Open seven bank accounts, five of which should be at one bank, and two at another.
- Fill out a grid (Profit First Instant Assessment) using information from last year’s P&L, personal tax return for every owner, and your year-end balance sheet.
- Resolve the discrepancies on your Profit First Instant Assessment over the course of six quarters (a year and a half).
There’s no tax section this week or next week because of our focus on profit-first methodology.
[01:46] – Moshe introduces what the show will cover this week.
[02:18] – The first thing to understand with saving for any goal is the time value of money. Moshe explains the importance of compounding interest with a clear example.
[05:16] – Moshe discusses the two factors that affect the growth of money: the rate and the time.
[07:03] – We learn how this relates to savings goals, which we’ve already broken into short-term goals, mid-term goals, and long-term goals.
[08:49] – Moshe offers a specific example to illustrate what he’s been talking about.
[14:36] – Most of the monthly savings amount in his example was for the short-term goal, Moshe points out.
[15:42] – Next week, we’ll cover strategies for how to save for these goals, and cover the logistics of how to calculate how much to save for each goal.
[17:17] – We kick off the business section of the episode.
[18:16] – Moshe dives into implementing profit-first in your business, which is a five-step process.
[18:24] – Step one is to get crystal clear on your motivation for implementing this system.
[19:23] – We move onto step two: opening a profit bank account.
[20:28] – Step three is to open seven bank accounts. Moshe explains in detail what each of the seven is for, and why they’re divided between two banks.
[25:25] – Moshe takes a moment to address the question of bank fees when you have so many accounts. There are several solutions to this, including CapitalOne’s Spark banking unit.
[26:32] – We learn about step four. To make this easier, text howtoprofitfirst to 44222, or get a copy of the Profit First Instant Assessment online.
[30:41] – Moshe offers an example using babysitting to explain the concepts he’s been talking about.
[31:55] – Moshe lays out some specific rules, and explains how to calculate your real revenue.
[32:57] – We learn the next steps of filling out the Profit First Instant Assessment, after having calculated the real revenue. He also discusses the difference between owner’s pay and profit.
[35:39] – Now that we’ve filled out the actual column, we move onto the TAP (Target Allocation Percentages) column.
[37:39] – The next column is just column A multiplied by column B. Moshe walks us through this as well as the final two columns.
[39:08] – You’re likely to be pretty sad when you look at the results, Moshe explains, because most businesses are way off on these numbers.
[39:43] – Step 5 involves resolving discrepancies gradually, because abrupt changes tend not to be sustainable.
[42:11] – Moshe introduces a new concept, the CAP (Current Allocation Percentage).
[44:32] – We discussed the 10-25 rule in the last episode, and Moshe now explains how you’re going to use that in your profit-first system.
[45:16] – The last part of this step is sending estimated tax payments.
[46:28] – Mike Michalowicz has graciously offered a special gift for listeners, as you’ll learn here. To sign up, go to this link.
Links and Resources:
Profit First by Mike Michalowicz
CapitalOne Spark Business Checking
Profit First Instant Assessment
DreamBuilder Financial Episode 1006