Individuals launching a solo practitioner business face a number of different challenges, whether it’s finding clients or proving a business plan or managing new responsibilities. But one issue that many don’t plan for – and can lead to a money crunch – is the sequence of when you receive payments. If there’s a significant gap, it can create credit risk.
As a sole practitioner, freelancer, contractor or small business owner, your income in the early stages of your business will be sporadic. But you pay expenses on a regular, monthly basis. This creates an issue if a client is late to pay or if a project stretches on longer than expected. Bills can come due while you wait for checks from your customers. While you have money on the way, you’re technically short of paying your bills.
How do you handle this issue, which will almost always be a dynamic at play when working for yourself?
There are two important steps to take to prevent credit risk from sinking your business.
First, look to build an emergency fund for your organization. It’s just like the emergency fund you hopefully have in your own personal accounts. Having six months of the expenses you will owe and the bills due will ease this concern. But unlike your personal finances, in your business account include the expense of the salary you will pay yourself.
If you’re expecting to pay yourself $5,000 a month, then build an emergency fund that’s closer to $30,000. This ensures you have payments for your organization, but also to send to yourself, covering mortgage, monthly bills, and food.
The second tool: determine what you need from a pay standpoint and pay yourself that amount each month.
As a sole proprietor, when business is good, there’s a temptation to pull all the money out as it comes in. But the more restraint you show during a boom time will ease the pressure that you feel when business slows down.
Instead, determine what you need from a pay standpoint to cover your costs from a personal standpoint. This should cover your mortgage, your monthly bills, and your other needs. You determine this by looking closely at your total financial picture – something that Thinking Cap Financial can help with.
Then, based on that, determine the need for the month. Now, don’t pay yourself more than that, until you have a proper emergency fund in place for your business.
Once you have the emergency fund in place, when things turn good, you can then pay yourself extra as additional (after tax) funds come in.
But until that protection is in place, showing restraint with how you pay yourself will reduce tension if expenses rise or business slows. It’ll help you to create stability in your income, instead of forcing you to live constantly on edge.