Hi. I’m Wayne Burgan and here is the story of my first business. It provides a simple example that illustrates the difference between Cash Flow and Profit.
One of my passions as a teenager was music.
But I was also reasonably entrepreneurial and although I had only been playing for a few years myself, when I was in high school, I started my first business, which was a guitar school.
My students paid me cash for the lessons, and I paid cash for the room where the lessons were conducted.
The cash I received for the lessons, (let’s say $500), was payment for my services and so this was ‘income’. The money I paid for room hire, (let’s say $200), was an expense in running the business so my ‘profit’ was the income minus the expense ($500 – $200 = $300). In this example, my profit happened to also equal my cash flow (receipts – payments.)
But to be able to teach guitar I had to own one myself. So, I bought a guitar that cost me $600. I had already saved $200, and my parents loaned me the other $400.
Now I had received $500 for the lessons and $400 from my parents, so now my ‘receipts’ were $900. And I had spent $200 on the room hire and $600 on a guitar so my ‘payments’ totaled $800.
My ‘cash in’ was $900 and my ‘cash out’ was $800 so my ‘cash flow’ was $100.
But the loan from my parents was not money I’d earned from my business. And the money I spent on buying a guitar was not an ‘expense’ of the business because I now had a guitar (an asset) to show for it. My profit was still $300 (my lesson fees less my room rent.)
OK, so far, we’ve just talked about cash.
One of my guitar students forgot to bring the payment with her for several weeks but I still gave her the lessons.
So, after 3 weeks she owed me $30 for the lessons I’d given her that she had not paid for. (Obviously this was a long time ago as guitar lessons are much more expensive these days.)
Even though I had not received the payment, I had provided the service and was entitled to be paid. I had earned the income. And because I had earned the income it becomes part of my profit even though I have not been paid.
If you look at it another way, I had loaned her the $30 she owed me and she had become my ‘debtor’. So, this is what is meant by the term ‘Debtors’ commonly used in some countries. It is also commonly referred to as ‘Accounts Receivable’.
So, I now have $30 in Accounts Receivable plus a guitar that cost $600. These are called ‘Assets’ – things that I own. And I owe my parents $400 for the loan. This is called a ‘Liability’.
This is really where I want to leave it for this discussion because if we get into talking about assets and liabilities and everything else, we’ll end up with a textbook. Suffice to say that money exchanged in relation to assets and liabilities affects your cash flow but not your profit.
It is important to understand that your income includes sales you make on credit and your expenses include purchases or other expenses you owe on credit.
It is also important to understand that as your business grows you have to collect the cash for sales you make on credit, or you could end up in a cash flow crisis.
For example, let’s say all my students were slow payers and I was owed the whole $500. But the landlord still wanted his $200 cash for the room rent. My profit is still $300 but my cash out is now $400 more than my cash in.
So, the next question becomes “where am I going to get the cash?”
If I don’t have cash reserves, I will be forced to either try to get the money in a hurry from the students who owed me (good luck) or borrow it from somewhere.
What if I can’t find anyone to lend me the money? Then my business is in trouble and I, as the business owner, am feeling the stress.
This is a simple illustration that demonstrates the need to manage the money owed to you very carefully! Many businesses have failed because their owners have been focused on making sales but not on getting paid for those sales.
It can go the other way too. For example, many businesses carry inventory as they need this to make sales. But the inventory ties up cash that does not turn into profit until a sale is made.
In conclusion it is important to recognize that cash flow and profit are not the same thing and the two terms and ideas behind them should not be used interchangeably.
While it’s good to keep track of the profit you’re making month after month, as we discussed in our previous article, you must keep an eye on cash flow as well.
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