Don't Mistake Profits For Cash
In business there are some fundamentals that are common to each and every organization regardless of size or type of structure. One of the most important of these is the management of profitability and cash flow. It is vital to understand the difference between them and the fact that profitability and good cash flow do not necessarily go together.
In fact, profitable businesses can go out of business because of cash flow problems.
How does that work?
Profit is the difference between sales and costs within a specified period, say a month or a year. But while a sale may have been secured and goods delivered, the related payment for the sale may be deferred, for instance as a result of giving credit to the customer. While you wait for receipt of your money however, you must continue making payments to suppliers for inventory, to employees for wages, for repayments on equipment and so on.
Sales, costs and, therefore profits, do not necessarily coincide with their associated cash inflows and outflows. The net result is that cash receipts often lag cash payments and, whilst profits are being reported, the business may still be experiencing cash shortfalls.
That can have two very serious consequences – at best a slowing in the rate of growth of your business; at worst, complete business failure. Rapid growth by profitable businesses may well lead to shortages of cash, because extra money is needed to finance expansion (for example to buy extra stock or purchase fixed assets). In extreme circumstances this can lead to failure. Knowing you'll have enough cash to pay a bill next month isn't enough if your creditors are pushing for payment today and you can't come up with it.
Good financial organization and having a strategy to manage cash flow will reduce the likelihood of disruption to your business. The strategy revolves around implementing effective business practices for improving cash flow and using a cash flow forecast mechanism to predict and manage slow periods.
Good practices for ensuring cash flow continuity
- Manage the credit you give – develop polices and procedures to ensure credit is only offered to reliable and profitable customers; reduce the average debtor's days outstanding by e.g. specifying payment terms on your invoices or charging interest on late accounts.
- Keep your books up to date – if your books are not kept up to date and accurate your cash flow forecast and other reports will not be accurate and the benefits of forecasting will be lost.
- Put contingency plans in place to borrow money at short notice for unexpected crises in cash flow. Better to be prepared than to have to arrange finance on unfavorable terms at short notice,
- Manage your bill payment schedule – don't pay early (unless good discounts apply) since that removes cash you could be using to earn interest or investing elsewhere; don't pay late since that puts suppliers, who might otherwise have been prepared to carry you over an emergency on the basis of your good reputation, offside.
- Fund your business properly – outlay of capital expenditure should be matched by long-term funding such as a term bank loan or a hire purchase agreement over a number of years. That way, the cash outlays are timed to coincide with the expected cash inflows to be derived from the investment in the fixed asset.
- Keep inventory to the minimum necessary – if you can decrease the amount of stock you are holding without decreasing your sales, then you have less money tied up in stock and have released cash into the business.
Forecasting – knowing and planning for the peaks and troughs of cash flow
Your cash flow needs constant monitoring and planning using a cash flow forecast report to make sure you always have enough ready cash to meet your costs on time.
Profit and cash flow are two factors that do not necessarily go hand-in-hand. More businesses fail for lack of cash flow than for want of profit. For this reason it is essential to manage the procedures that determine cash flow and to forecast the cash flow situation to be aware of where there may be problems looming.
Having the right procedures in place can help you manage your cash flow effectively. Both your accountant and your business advisor can help by looking at your processes, recommending changes that will protect cash flow and providing you with a regular cash flow forecast.
At InConcert Financial Group we are happy to help you evaluate your cash flow management system and determine if it supports the business operations and expansion strategies. Our desire is to help you run your business efficiently and enjoy a
prosperous growth, therefore if you need assistance in any of the cash flow issues please call our consultants at (510) 235 1044.