Many self-employed business owners have not been educated or had much experience in accounting. Consequently, the financial side of the business can be a chore they do not look forward to. I once had a very well-educated engineer as a client who struggled to grasp that he had to pay taxes on his profits and not just the money taken from the business for his personal use.
A concept that many small business owners struggle to understand is the difference between profit (as disclosed in the Profit and Loss Statement) and cash flow (as reported in the Cash Flow Statement.)
“The key difference between cash flow and profit is while profit indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a business.” (https://online.hbs.edu/blog/post/cash-flow-vs-profit)
Click here for a practical case study explanation of the differences between profit and cash flow.
A business that makes a profit does not necessarily have positive cash flow. Let’s look at several scenarios to understand how these two accounting concepts differ.
Example 1 – Good Profit and Good Cash Flow
Business 1 has good sales and a reasonable profit margin, and its gross profit exceeds its overhead expenses resulting in a profit. A large portion of their sales are paid upfront, and their accounts receivable is minimal. As a result, the cash coming into the business from sales outweighs the money going out in expenses, and the company has a positive cash flow.
Example 2 – Good Profit and Poor Cash Flow
Business 2 has been making a reasonable profit. However, a piece of equipment breaks down unexpectedly, requiring either an expensive repair or replacement. A substantial portion of sales is made on credit, and there is a large accounts receivable balance as they have not paid enough attention to following up slow payers. As a result, the cash coming into the business is insufficient to meet the costs. This could mean they will have to get a loan, delay other payments or cut expenses that could negatively impact the business’s future profits. Even though the company has good sales, not managing cash flow well has caused trouble.
Example 3 – A Loss and Poor Cash Flow
Business 3 is a start-up. The owner has done her planning well, minimized her expenses by working from home and organized her start-up finances. Year 1 had a good profit, but the business has gone so well she has woken the competition who are watching, copying her every move, and cutting prices (to even below cost in their regular sales). Unfortunately, she has had a catch-22 in that she needs to move into bigger premises and advertise more to increase sales. This means extra costs, and responding to the actions of the competition has reduced the sales margins and now resulted in a loss. She knows that the competition cannot keep selling below cost, so careful planning and external finance are required to weather the storm.
Example 4 – Positive Cash Flow but No Long-Term Profit
Company 4 is a different case. Expenses have exceeded sales for some time, and the lease is ending, so the owner has decided to close the business. He is selling off as much of the plant and equipment as possible before he closes. This brings in cash, enabling him to meet his expenses for the time being. However, the positive cash inflow is unsustainable as it results from selling off assets, not regular trading.
Examples 1, 2 and 3 are pretty common, whereas a business with a positive cash flow but no long-term profit, as in example 4, is less common.
Cash flow problems can affect most small businesses at one time or another. If a company cannot pay its bills as and when they become due, it is considered insolvent and may face bankruptcy or closure.
Accordingly, you need to be proactive in managing your cash flow.
The first step in proactive management is to track cash receipts and payments. For example, knowing how much money you can expect to come in over the coming days and weeks helps you plan better and reduces stress.
In example 2, the business got into difficulties because it did not have a system to follow up with slow payers. This is a business sin. If you have to make sales on credit, ensure you have a system of follow-up that is used meticulously.
You can track your accounts receivable in your accounting system by reviewing how long invoices have been outstanding and follow-up as soon as they are overdue. Also, keep track of the days it takes to receive the cash from accounts receivable (Accounts Receivable Days). Click here for the formula.
Over time, you will also see patterns emerge that will help your planning. For example, when customers pay their invoices, you may receive more cash at the beginning of a month. In addition, your business might have seasonal variations or sales bumps around specific holiday promotions.
Tracking your cash flow will help you plan the timing for equipment purchases and investments or when additional finance might be required to meet cash shortfalls.
Here are the steps to create a cash flow budget for a small business:
Along with tracking, your budget is essential to managing your cash flow. It should be regularly reviewed as things can change rapidly, and you do not want to be caught unprepared.
In conclusion, running out of cash is a significant reason for small business failure. Therefore, understanding and managing your cash flow must be a priority in your business.
This is the final article in this month’s series on essentail small business finance skills. Other articles in this series include:
The 3 Financial Statements Small Business Owners Must Understand
Analyze Financial Statements: Know Your Numbers
How to Hire a Bookkeeper
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