Fundamentally, the best way to build wealth consistently is to spend a little less than you earn. The more you earn and the less you spend, the more money you have left over at the end of each month. Building a habit of making life decisions that support this concept is a sure fire way to set yourself up for long term success.
But if you’re able to do so, where should that extra cash go?
Most families I’ve ever worked with are familiar with the concept of an emergency fund. But how large should yours be? How much money do you need to keep in your business? When should you start paying off those pesky credit cards?
Followers of Dave Ramsey may be familiar with his “Baby Steps” system to help prioritize where to send extra cash. It’s essentially a financial order of operations to use as a framework for wealth building.
I’m not a huge fan of Dave Ramsey, but his baby steps are mostly sound. (And have helped countless thousands of people around the world). They’re not terribly helpful for business owners though, since they don’t cover a company retirement plan or what to do with business cash.
That being the case, I’ve laid what I believe to be the business owner’s financial order of operations in this post.
Step 1: Establish a Basic Emergency Fund
An emergency fund is liquid cash you can access if your life goes sideways unexpectedly. The roof caves in. The springs on your garage door snaps, like mine recently did. Maybe the economy turns and revenues dry up.
Whatever the reason, it’s important to have a little cash available for a rainy day. This way you don’t need to tap into your investments or retirement accounts at an inconvenient time. Or worse, take on debt unnecessarily.
Establishing an emergency fund is financial planning 101, and should always be done before any other type of saving & investing. You don’t need a massive emergency fund at first though. A basic emergency fund totaling one months’ worth of your living expenses should be sufficient.
Step 2: Establish Basic Working Capital
Just like everyone needs an emergency fund for their household, so too does your business. Accountants like to call this available business cash “working capital”. While you’ll probably want to build up a nice cash reserve in your business over time, start by accumulating one months’ work of operating expenses.
Your operating expenses should include your own salary and/or compensation, if applicable. One months’ worth of expenses isn’t a massive amount of money, but will help keep the lights on if things get tight.
Step 3: Pay Off High Interest Rate Debts
Millions of people across the U.S. consistently carry balances on their credit cards. This is a major windfall for banks, which typically charge north of 20% per year in interest.
As soon as you have a basic emergency fund and basic working capital in place, focus hard on paying off all high interest rate debts. I classify “high interest rate” as anything greater than 10%. While this includes pretty much all credit cards, it could also include personal lines of credit, auto, and/or student loans.
Step 4: Complete Full Emergency Fund
Carrying one months’ worth of expenses in a basic emergency fund is a great start, but isn’t quite enough long term. Many things can happen that might require more than one months’ of expenses, or require you to suspend your income for more than one month.
Financial planners typically like to recommend 3-6 months’ worth of expenses as an emergency fund. Business owners are a little different, as they take on more risk than most w-2 employees. While it depends on the circumstances, I typically recommend that business owners maintain somewhere between six and twelve months’ worth of expenses as an emergency fund. This allows them to suspend their own compensation if business gets tight or an unexpected expense arises.
This may seem like a lot, which is true. But just like a basic emergency fund, having cash for a rainy day can help you avoid tapping your credit lines or retirement accounts before you’re ready.
Step 5: Complete Full Working Capital
Businesses don’t typically need a full year’s worth of cash in the bank for a rainy day. I’d recommend more than one month though. An appropriate range will usually be three to six months’ worth of operating expenses, again including your own compensation.
Appropriate working capital for your business will depend a lot on your industry, growth objectives, and how capital intensive your business is. Newer businesses might have fewer long-term contracts with vendors, meaning you could reduce costs in a pinch if you really needed to. Which also means you probably don’t need as much cash on hand.
On the other hand, you might be in a more seasonal or volatile line of work. In which case you should keep more cash around for the leaner times you know are coming at some point.
Step 6: Establish a Company Retirement Plan
Keeping some available cash in your business and household accounts is critically important for long term financial stability. We don’t want to hang onto too much cash though. The interest rate banks might pay you on savings in a high yield savings accounts will almost certainly be less than what you can expect in a properly invested portfolio.
Once you have your emergency fund & working capital in place and your high interest debt is paid off, it’s time to start positioning your extra savings for growth through tax advantaged retirement accounts. Since the government wants us all to save for our own retirement, they offer businesses a wide variety of tax advantaged retirement accounts you can take advantage of. The most common types you’ll see are SEP-IRAs, SIMPLE IRAs and 401(k) plans.
You have a wonderful opportunity to establish a company retirement plan in a way that supports your personal and business goals. Even better, contributions you, the business, or your employees make to these types of accounts are typically either tax deferred or tax exempt.
Be sure to scrutinize the type of retirement plan you’re establishing, understand the contribution commitments, and begin to make contributions for yourself. They don’t need to hit the annual maximums yet. But if your plan includes some form of match or employer contribution, be sure to put in enough yourself to take advantage of it.
Step 7: Pay Off Non-Mortgage Debts
With your retirement savings kickstarted it’s time to circle back to debts. For most people any non-mortgage related debt will be auto loans or loans for other toys like boats, jet skis, or snowmobiles.
Some will argue that if you have a good rate on these debts you should only make minimum payments. For example, let’s say you’re on step 7 after completing steps 1-6. You have $1000 in extra cash each month after expenses. You also have an auto loan of $12,000 at a rate of 3%.
The math tells us that you’d be better off long term investing the extra $1000 each month in your retirement plan than paying off the auto loan. This is generally true. A properly invested portfolio should return far more than 3% per year over the long run.
A reasonable assumption for long term returns in an investment portfolio might be 7%. Since this is greater than the 3% interest you’re paying on an auto loan, you’d be better off long term investing the $1000 each month than paying the loan down more aggressively. Plus, you may get to deduct the contributions if they go into a tax advantaged retirement account.
While all this is true, there’s a lot to be said for paying down debts first. It frees up cash flow, builds financial strength, and gives you more long term financial flexibility. Plus, the 3% interest the bank is charging you is guaranteed. The 7% returns we might expect in an investment portfolio is not.
Steps 1-6 are somewhat rigid, and I can’t think of too many good reasons you’d want to adjust their order. A stronger case can be made for swapping steps 7 and 8. If you’re comfortable carrying more debt, taking a little more risk, and want the math to work in your favor, proceed at your discretion.
Step 8: Maximize Retirement Account Contributions
Establishing a company retirement plan often comes with a commitment to make contributions on behalf of your employees. This may be through a company match, a flat percentage of your employees’ compensation, or a portion of profits left over at the end of the year.
Though you already started making contributions to a retirement plan in step 6, you’re probably not hitting the maximum contribution limits yet. In this step, contribute as much as you possibly can to tax advantaged retirement accounts. This includes the plan you’ve already set up through your business, as well as traditional and/or Roth IRAs.
While the amount of cash required to hit your annual limits may look daunting, every dollar you put into a plan comes with substantial tax advantages. Your contributions will be treated either as a deductible contribution, or a Roth contribution that will grow and compound tax free forever. With all your non-mortgage debts paid off, it’s time to ring the bell on tax advantaged retirement savings.
Step 9: Save For Kids’ Education
Most people I’ve advised over the years mis-prioritize college savings for their kids. While we all want to help our kids pay for college while avoiding massive amount of student loans, it’s a huge mistake to put your kids’ education ahead of your own financial independence.
Remember – even though it’s undesirable, your kids can always borrow money to go to school. You won’t be able to if you find yourself destitute at age 80. Plus, your own financial independence is a far bigger gift to them than their college costs. I’d much rather have to pay my own way through school than have my parents rely on me financially in their older years.
When you get to this point, 529 plans are the best option for most people. Some states will even give you a state income tax deduction if you make contributions to your home state’s plan. Education savings accounts have merit, but the contribution limits are low enough for most people to eliminate them as an option.
Step 10: Build Wealth
If you still have cash left over after establishing a full emergency fund & working capital, paying off all your non-mortgage debt, maxing out your retirement accounts AND funding your kids’ college savings plans, I can officially state that you’re doing very well.
You’re also at a point where other wealth building opportunities are beginning to make sense. This may include:
- Investing in taxable accounts
- Alternative and/or private investments
- Real estate (either income or vacation properties)
- Paying down your mortgage aggressively
- Investing back into your business to grow faster
- Acquiring other businesses
In step 10 you have the discretion to decide. You can pursue the risky passion project you’ve always had in mind. You could start picking up rental properties nearby. Maybe you go in with some friends to buy a bar that will probably lose money. (Side note – bars and restaurants are terrible businesses to buy and almost always lose money).
The point is that you’ve laid a great foundation. You’ve taken advantage of all the tax qualified opportunities available. You’re now in a position of strength, and have the capacity to take more risk.
Note that you don’t have to continue building wealth, either. Once the first nine steps are checked off the business owner’s financial order of operations, you’re at a perfect point to accelerate charitable giving. Ramping up donations to your favorite charity, perhaps through a donor advised fund, is a wonderful way to live your values while simultaneously building wealth.