Don’t be Fooled by Profit – Cash is Where Things Flow
Dec 3rd, 2007 by admin
A number of years ago, I had the privilege of working for a brilliant man. He was an educated business professional, a skilled engineer and a gifted inventor. The problem? He had no clue what cash flow was and eventually ran his business into the ground. At the closing of each month, the first item that he requested was the income statement. If it showed a profit, everything was golden and he would start burning a hole in the corporate checkbook. Month in and month out, I tried to explain to him the significance of cash flow. We may have posted a profit, but the cash going out the door was not in sync with the cash coming in. This resulted in serious cash flow problems.
I left before the cash flow stopped altogether, but often reflect on this story as a reminder of how misunderstood cash flow is. You see his story isn’t all that unique. Many entrepreneurs struggle to understand the difference between cash flow and profits. Although a business needs to have both to survive, cash flow is the more critical of the two. Cash flow simply refers to the flow of cash into and out of a business over a period of time. It is what you need to have to keep your doors open while you’re busy trying to make a profit. Without cash, a business cannot pay its suppliers, meet payroll or operate effectively. Eventually the cash flow stops. If that happens, you’re out of business.
There are several reasons why the net profit line on your income statement can be very different from actual cash that you have available – referred to as free cash flow. Free cash flow is ready money in the bank. It is not accounts receivable, it is not inventory and it’s certainly not net profits. For most businesses, the timing of when you make a sale to the point in time when you actually receive payment from your customer is 30 days or more. These are called extended credit terms and most businesses need to offer these to their customers in order to stay in business. It’s customary and expected, unless you’re a retailer or other traditional cash-based business. So, profits are not a reflection of your day-to-day cash position. During the time that you’re waiting to receive payment, you still need to pay your everyday bills and expenses. Profits do you little good if they’re not accompanied by positive cash flow. Think of it this way: you can’t write a profit, but you can write a check – which should correlate with actual cash that you have on hand in the bank. This is why managing the inflows and outflows of cash should be a top priority for every business owner.
To get a handle on cash, know when, where and how your cash flow occurs; plan ahead for seasonal fluctuations and unexpected emergencies (i.e. establish a contingency fund) and keep positive relationships with suppliers, bankers and business partners. Someone once said “Cash flow is king.” Don’t be a joker. It’s time to hail to the king!
