If I had a dollar for every time I sat down with a client and told them what their profit for the year was, and they said, ‘But I don’t have that much money in my bank’, I would be rich. So what’s the difference? And why does it matter?
Profit is the money left once expenses are paid. Some people think business owners can take profit to the bank. If only! Profit is used to pay for any new equipment or materials the business needs to grow. And, unless you buy a politician or two (which I do not recommend), you also pay taxes from profits. Only after paying for growth and taxes do owners get to take money home.
Profit = Total sales value less the cost of stock and other expenses (excludes GST)
Cash = All cash inflows less all cash outflows (includes GST)
What the calculation of profit does not show is how much of that profit needs to be held to allow the business to grow. In other words, to invest in more stock, materials, plant and equipment.
Available cash, on the other hand, is affected by how long our customers take to pay us, how long it takes to pay suppliers, whether we are growing as a business, what we are drawing out of the business in personal spending, loan repayments, income tax payments and the new assets we need to buy (for example, a new truck) from time to time.
The link between profit and cash is simply timing – we call this the working capital cycle.
So why does this matter? A profitable business can fail because it’s starved of cash. On the other hand, a company making a loss can survive because it has access to funds from investors or financiers.
If you are in a position where you report a good profit, but you simply don’t know where all the money is, it is worth looking into a few things. There are many causes of poor cashflow but here are the top seven:
• Poor accounts receivable process – resulting in debtor days (the time between billing and banking) being too high, stifling your cashflow.
• Accounts payable process – a review of all suppliers’ terms may identify ways to improve cashflow or just get better terms of trade.
• Carrying stock for too long means full shelves but an empty bank account. This is no different if you’re a service provider with work in progress that is yet to be billed.
• Maybe your debt/capital structure needs to be reviewed? Perhaps your debt should be consolidated and paid off over a longer term? Maybe you need to look honestly at your drawings from the business, or does the business need an injection of capital to fund its growth? Often significant cashflow and interest charge improvements can be achieved with a regular review of existing debt.
• Overheads – every business should thoroughly review its overheads every year.
• Low gross-profit margins is another way of saying that your variable costs are too high. There are many strategies you can implement to improve margins.
• Finally, sales levels are just too low to support the business’ overheads and other cash demands. This comes down to how viable the business is. If the business is in high growth mode and sales are increasing rapidly, it needs finance to support that growth, and we need to review a financing plan. If the company isn’t in growth mode, the focus should be on how to grow sales.
If you are reporting a good profit but are starved of cash, it is worth investigating why that is – there is a lot you can do to improve it. It ultimately will come down to planning – a bit of cashflow planning goes a long way to get the cash you desire from your profits.
