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Profit vs. Cash Flow: Healthy profits but anemic – Diagnosis is money squeeze.
Having adequate cash flow is essential to keep a business running. If your company runs out of available cash, it runs the risk of not being able to meet current obligations such as payroll, accounts payable and loan payments. Many managers don’t have a handle on even calculating the cash flow generated by their business much less have creative thoughts about how to “make it til Friday”. This primer on the subject starts with defining the key elements, how to make the proper sub-calculations required (eg operating, investment, financing cash flows) as well as techniques to help you survive cash flow crunches that affect every company. This not to missed testament covers how to predict future cash flows the importance of doing so, detecting financial difficulty early before real trouble hits, how on the fly management decisions influence long-term cash flows. We also provide our “short list” of where to start in an emergency. Many people reading this will ruefully remember the day they first really understood the statement ‘profit is not cash flow’; many more have yet to experience that pain. This paper is both crowds. It is both an Ebenezer – reminder – and an Icabod – a caution. There are several reasons why the profit line on an income statement can be very different from money available to spend from a bank account. It gets worse - profit in any given period does not always translate into free cash1 that the owner can draw as a salary. Perhaps the most common reason there is a discrepancy over cash flow and profit is the difference in timing between the making of a sale and actually receiving the money. In its most simple form a business may sell something on credit, but not collect the money until the next month or two or three. In these instances, the revenue from the sale is recognized for accounting purposes in when the product or service was sold. In financial statement terminology, it is added to the “Income Statement” or P&L Statement. Companies with savvy management teams generate profit and loss statements monthly so that they can examine the total sales, cost of goods sold, total operating expenses and net profit, and the interrelationship of these buckets. However, the money owed by the entity, which purchased the good or service, is recorded as an asset on the company’s balance sheet in that the same month that it was sold. It will be “carried there”, i.e. it won’t move a muscle, until the greens of the greenbacks hit the company’s account. Once paid in the following month or two or three (let’s be realistic) the asset recorded as a receivable representing the debtor which purchased your good or service, is morphed from a receivable into cash. Voila! No phone booth. No fancy spandex. Just a move usually one line up on your company’s balance sheet and still an asset on the balance sheet. However, a critical tipping point to your company’s operational capability: those are now funds which can used to pay expenses rather than illiquid “ladies in waiting” just occupying space on your financials. The point is this – the actual receipt of the cash is not reflected in the income statement and hence profit in the month you receive it. It gets bumped over to cash received in a later time period thus there is a natural time delay between the time you have money to spend from a sale and the time you actually record the sale. Now that you get the rhythm of the beat, let’s cut to the dance floor for a disco discussion. There are several ways in which this recognition/reception timing issue can cause problems in your business. A growing business, which sells a high proportion of goods or services on credit, will “show” ever-increasing profits erstwhile an ever-increasing accounts receivable representing... [continued...] Want to know more? Download the White Paper "Profit vs. Cash Flow: Healthy profits but anemic – Diagnosis is money squeeze." for just $29.95. |
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