Profitability Does Not Necessarily Mean Good Cash Flow
Cash flow is not the same as profitability. A profitable business can still be unable to pay its bills. Similarly, just because a business is meeting all of its financial obligations, doesn't mean it's profitable.
Profit is an accounting term, which really only exists on paper. Measuring profit is a very specific way of looking at a business. It doesn't tell you a whole lot about how the business is getting by day-to-day.
Improving cash flow is a smart move for any business.
It doesn’t matter how great your business model is, how profitable you are, or how many investors you have lined up. You won’t survive if you can't manage your company's cash.
In fact, one study found that 82% of businesses fail due to poor cash flow management skills. If you're looking for one area to focus on that will have a dramatic impact on your business, this is it.
Getting good at managing cash flow is one of the best things you can do for your business. Not only that, it's a skill you can carry over into other businesses, as well as your personal finances.
Calculating Profit
Profit is typically calculated in two steps. The first is to take your total revenue and subtract the cost of the goods sold. The difference is your gross profit.
Revenue — Cost of Goods Sold = Gross Profit
For example, if you sold $100,000 in rocking chairs, and the chairs themselves cost you $50,000 wholesale, your gross profit would be $50,000.
Of course,
you would probably have other expenses beyond buying the chairs. For example, you’d need a place to store the chairs, and you might want to run some ads to get more sales. These expenses are called operating expenses and they get subtracted from your gross profit.
Operating expenses include most costs that are not directly connected to what you’re selling. Things like rent, equipment, payroll, and marketing.
The second step to calculating profit it to subtract operating expenses from gross profit. The difference is net profit.
If your net profit is a positive number, you made money. If it’s a negative number, you lost money. This report as a whole is called the income statement or profit and loss (P&L).
The Problem With Profit
The problem with income statements is that they don’t show your whole business. A few very important pieces of information are missing.
1. Debt Repayment
If you have any business loans or other startup capital to repay, it won't show up here. Only the interest on those loans will be included on a P&L. Even though debt repayments can eat up a lot of cash.
2. Equipment Payments
Similarly, if you make a major equipment purchase, the entire cost will not show up here. Instead, that cost will get spread out over the lifetime of the equipment. If you spend $100,000 on a canning line and you think it will last you ten years, your income statement will show an expense of $10,000/year for ten years. Even if you had to pay all of it up front.
3. Taxes
It’s also important to note that your net profit hasn't been taxed yet. This means it's going to shrink even more. Even if all of your profit is available in cash, you won’t be able to run out and spend it all in one place.
4. Cash Received
Finally, many businesses use accrual accounting, which records revenue even if you haven't received the money yet. On paper, you might have $200,000 in sales but if nobody has paid you yet, you're still going to have a hard time paying the bills.
Further, if you carry inventory, all that product has value and gets included on your income statement as well. Of course, in order to extract cash from your inventory, you need to sell it first.
You can start to imagine why profit has little bearing on cash flow. Here's the deal with profit. If you're not profitable on paper, you're in bad shape. You need to either increase your revenue or decrease your expenses if you want to stay in business.
But just because you're profitable, doesn't mean your business can run on autopilot. You still need to watch your cash—especially if you're growing.
Most businesses work best by planning week-to-week. However, some may need daily, others only need monthly. It's also up to you if you want to include every single expense or just categories of expenses. These decisions will depend on the scale and complexity of your business.
Similarly, some businesses will be able to project their cash flow accurately for six months, others only two weeks. In general, try to project four to six weeks reasonably accurately. A good rule of thumb is that the farther you are into the future, the less accurate your predictions will be. As you forecast revenue each week, be mindful any dips in sales due to holidays, the time of month or year, as well as any promotions or major deals that will impact your revenue.
Most companies simply can't survive without good cash flow management. But anyone can do it. Take the time to get organized now and it'll be easy to stay on top of it.
Improving cash flow is a smart move for any business.
It doesn’t matter how great your business model is, how profitable you are, or how many investors you have lined up. You won’t survive if you can't manage your company's cash.
In fact, one study found that 82% of businesses fail due to poor cash flow management skills. If you're looking for one area to focus on that will have a dramatic impact on your business, this is it.
Getting good at managing cash flow is one of the best things you can do for your business. Not only that, it's a skill you can carry over into other businesses, as well as your personal finances.
Calculating Profit
Profit is typically calculated in two steps. The first is to take your total revenue and subtract the cost of the goods sold. The difference is your gross profit.
Revenue — Cost of Goods Sold = Gross Profit
For example, if you sold $100,000 in rocking chairs, and the chairs themselves cost you $50,000 wholesale, your gross profit would be $50,000.
Of course,
you would probably have other expenses beyond buying the chairs. For example, you’d need a place to store the chairs, and you might want to run some ads to get more sales. These expenses are called operating expenses and they get subtracted from your gross profit.
Operating expenses include most costs that are not directly connected to what you’re selling. Things like rent, equipment, payroll, and marketing.
The second step to calculating profit it to subtract operating expenses from gross profit. The difference is net profit.
If your net profit is a positive number, you made money. If it’s a negative number, you lost money. This report as a whole is called the income statement or profit and loss (P&L).
The Problem With Profit
The problem with income statements is that they don’t show your whole business. A few very important pieces of information are missing.
1. Debt Repayment
If you have any business loans or other startup capital to repay, it won't show up here. Only the interest on those loans will be included on a P&L. Even though debt repayments can eat up a lot of cash.
2. Equipment Payments
Similarly, if you make a major equipment purchase, the entire cost will not show up here. Instead, that cost will get spread out over the lifetime of the equipment. If you spend $100,000 on a canning line and you think it will last you ten years, your income statement will show an expense of $10,000/year for ten years. Even if you had to pay all of it up front.
3. Taxes
It’s also important to note that your net profit hasn't been taxed yet. This means it's going to shrink even more. Even if all of your profit is available in cash, you won’t be able to run out and spend it all in one place.
4. Cash Received
Finally, many businesses use accrual accounting, which records revenue even if you haven't received the money yet. On paper, you might have $200,000 in sales but if nobody has paid you yet, you're still going to have a hard time paying the bills.
Further, if you carry inventory, all that product has value and gets included on your income statement as well. Of course, in order to extract cash from your inventory, you need to sell it first.
You can start to imagine why profit has little bearing on cash flow. Here's the deal with profit. If you're not profitable on paper, you're in bad shape. You need to either increase your revenue or decrease your expenses if you want to stay in business.
But just because you're profitable, doesn't mean your business can run on autopilot. You still need to watch your cash—especially if you're growing.
Most businesses work best by planning week-to-week. However, some may need daily, others only need monthly. It's also up to you if you want to include every single expense or just categories of expenses. These decisions will depend on the scale and complexity of your business.
Similarly, some businesses will be able to project their cash flow accurately for six months, others only two weeks. In general, try to project four to six weeks reasonably accurately. A good rule of thumb is that the farther you are into the future, the less accurate your predictions will be. As you forecast revenue each week, be mindful any dips in sales due to holidays, the time of month or year, as well as any promotions or major deals that will impact your revenue.
Most companies simply can't survive without good cash flow management. But anyone can do it. Take the time to get organized now and it'll be easy to stay on top of it.
Credits: shopify.com
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