Sales and profit are two very different things – as a business owner, you can find yourself without the cash to pay bills despite making sales you knew were profitable. You may also be startled to discover that strong cash flows from sales actually deliver little profit.
Common issues are:
“The profit and loss account shows I’ve made a $50,000 profit (and now I owe tax), but the cash in the bank is $0. The figures don’t match up. Where’s the missing profit?”
“We’ve been extremely busy these past few months. Sales are booming – but I can’t see any cash left over each month.”
What exactly is cash flow?
A cash flow forecast tracks cash flowing in and out of your business. The timing of these flows enables you to identify cash-rich and cash-lean periods and helps in making the right decisions, such as when to buy assets or when to prepare for cash shortfalls.
A definition of profit
Profit is the money left in your business after all your expenses have been paid. An income statement (also referred to as a profit and loss report) reveals what profit your business made last month or last quarter. Your profit’s detailed in two figures, namely:
Gross profit – what’s left from sales after deducting the costs of goods sold or services provided.
Net profit – what’s left from gross profit after operating costs (your business overheads) have been deducted. This is the figure you are taxed on.
Note that net profit still isn’t the final ‘bottom line’ profit until all taxes have been paid.
Why cash flow and profit can differ
The gap between the cash in your business and the profit you report at the end of the year will (almost) always be different, as some of the things you buy with cash are not fully deducted in the profit and loss account.
Cash flow in that’s not counted as revenue
A cash flow forecast records actual cash transactions over the year and can be by inputs other than sales, such as:
Capital injections by the owner or investors.
Money you’ve borrowed.
Cash from selling assets.
These sources of cash can help fund your business, but they don’t add to your end of year profit, as they’re not related to revenue. If you put $100,000 of your savings into your business bank account but didn’t actually start trading and so had $0 sales, your cash flow would be plus $100,000, but your profit would be $0.
Cash flow out that’s not fully counted as an expense
Sometimes you can’t count an expense or money out in your profit and loss either. For example:
Any extra drawings by you as the owner, as it’s not counted as an ‘expense’ in the profit and loss account. To be included as an expense you’d be better to either take a wage or salary and pay PAYE like a normal employee.
If you buy any assets, instead of deducting the total value as an expense, you instead ‘depreciate’ the asset each year. If you bought a $10,000 asset and it should last 10 years, then you’d only be able to count $1,000 as an expense in year one (which you’d repeat for the next nine years until the asset is fully ‘depreciated’).
An increase in inventory or raw materials. At the end of each year you only include as an expense how much product your business ‘used up’ over the year. There will be an imbalance if you end up with much more inventory than you started with.
These scenarios help explain the gap between cash flow and profit.
Sales are great, so we must be profitable
Inexperienced business owners can easily confuse ‘being busy’ with being profitable, but there’s a very clear distinction between them. Your profit is always what’s left after all costs have been deducted.
If you haven’t calculated your selling prices correctly, your ‘thriving’ business may in fact be operating at a loss. The cash flow may seem great, but the profit and loss account reveals the true picture.
The critical lesson here is to never set your prices until you know all the costs involved. You might end up operating at a loss or at an unsustainably small profit level.
We’ve made many profitable sales but can’t pay our bills
It’s quite possible to run out of cash or go bankrupt by taking on too much business too quickly, even though each sale is profitable. This is called overtrading – and businesses that sell on credit rather than cash terms are more at risk.
Actions that can lower cash flow
Reasons businesses can run out of cash include:
Excessive withdrawals by the owner(s).
Purchasing too much inventory relative to sales.
Taking on more loans than the business can service.
Buying assets at inappropriate times (such as during a slow period).
Pre-payments or paying suppliers too soon. If suppliers offer 30 days, it makes sense to take advantage of the full credit period.
Cash flow is all about the timing of money inflows and outflows.
If you expend significant cash to pay operating expenses and miscalculate the actual time to collect customer receivables, or your business is poor at collecting on overdue accounts, you can easily use up all of your cash paying suppliers and other bills while waiting to collect amounts owed by customers.
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