To those without a business background, it’s fairly easy to confuse cash flow with profit. They’re not unrelated, but it’s important to understand how both concepts impact the operation of your business. An explanation of this interrelationship requires an understanding of basic accounting principles.
Your business is racking up sales and the money’s rolling in. Bills are getting paid and on the surface, things seem to be going pretty well. You might even be making a profit, but you won’t know for sure without having a financial management system in place.
The cash method records the actual movement of cash through a business. It recognizes expenses on the date they’re paid and recognizes income on the date cash is collected for a sale. This method closely tracks the actual inflows and outflows of cash.
The accrual method matches income and expenses. It recognizes expenses on the date they’re incurred, not when they’re paid. Likewise, it recognizes income on the date of sale, even if payment is not received on that date. While most accountants recommend this method and many businesses are required to use it, it does complicate the tracking of cash flow due to the timing differences.
When your sales revenue or receipts exceed total expenses, you’re making a pretax profit. Determining revenue is the easy part. It’s the sum of all products or services sold during a specified period. Daily, weekly, and monthly sales figures can be used to track trends and refine annual goals.
Determining expenses is more complex and requires an understanding of basic finance and accounting. It’s the total dollar value of time, money, and resources utilized to produce and sell your product or service. It’s a combination of both direct and indirect costs.
Direct costs are incurred for a specific product or service and include all the labor, parts, and material cost. They are variable in nature and are largely a function of the number of units produced. The more you make and sell, the lower the unit cost will be. This provides more pricing flexibility and the ability to increase profit margins.
Indirect costs are often referred to as “overhead” and are spread over everything that you do. They include rent, utilities, office supplies, advertising, company benefits, equipment maintenance, vehicles, capital expense, and loan payments. These costs are relatively fixed over time and can be controlled to some degree with careful planning and budgeting.
Cash flow is a measure of the movement of money over time, and your goal is to keep it positive or in your favor. Cash inflows usually result from company operations, financing, or investing. Cash outflows usually result from company expenses or investments. Some companies prepare a “statement of cash flows” that reports the amount of cash generated in a specified period. Generating cash is the goal of any business and it’s used as one indication of financial strength.
There are ways to maximize how you manage the incoming and outgoing cash streams. You want the rate at which money comes in to exceed the rate that it’s going out. Here are some suggested techniques for improving cash flow:
- Keep inventories as low as possible and still meet projected demand
- Offer discounts to cash customers
- Get paid on delivery for product sales
- Monitor and follow up on all invoiced sales to ensure prompt payment (reduce accounts receivable)
- Negotiate favorable payment terms with suppliers to hold onto your money as long as possible (increase accounts payable)
- Set up electronic payments to pay your routine bills exactly on the due dates (increase accrued expenses payable)
- Reduce the production times for your products
- Compare actual cash flow performance to your forecast, and implement corrective actions where needed
To some degree, profit and cash flow engage in a “chicken or the egg” relationship. Making a profit generates cash, but it takes cash to pay the bills and keep the business operating. If those bills aren’t getting paid, it won’t be long before those profits dry up and the cash flow slows down or stops. In a sense, timing is everything.
If you spend $100 to make a product and sell it for $150, you’ve made a $50 profit under accrual accounting. But what if you don’t receive the $150 until three months after the sale occurs? During those three ensuing months, you still have to pay your bills that don’t go away while you’re waiting for your money. Unless you have other sources of cash, your negative cash flow is a significant problem.
Profit only compares income and expense at a single point in time, but this snapshot may not present an accurate picture of how your business is really doing. Cash flow is a dynamic representation of the amount and timing of money moving into and out of your business. It’s more aligned with reality, and how it’s trending will provide valuable insight into the health of your business.
Making a profit clearly helps your cash flow, but the cash generated could be more or less than the amount of profit. For many reasons, positive cash flow doesn’t necessarily mean you’re turning a profit. For example, if you hold a fire sale on your entire existing inventory, that will generate a lot of cash at the time you do it. However, if you’re selling that inventory for less than it cost, you won’t make a profit.
Offering timely discounts to customers may have an immediate negative effect on profit, but will simultaneously improve cash flow and may increase sales volume. Both have potential long-term benefits to the bottom line.
Many small business owners become overwhelmed when they discover the unexpected complexities of financial accounting. While this brief overview of profit and cash flow may help to understand these concepts, you should seek the services of a professional accountant to set up your financial recordkeeping.
An accountant can provide regular reports and trend analyses for profit, cash flow and many other financial indicators that are keys to your future success. The bottom line is that you want to be in compliance with all applicable laws and regulations, and you don’t want problems with the IRS.