Learn Why Cash Flow Beats Profit

Cash flow refers to the flow of money through your business. It usually goes out so you can buy stock and pay expenses, like wages and rent, and comes back when you sell that stock and collect the money from the buyer.  Profit is an accounting term trying to show income less expenses. It suffers from so many accounting ‘treatments’ that it is not much use for small business managers.  This might sound like a “dry” topic, but mismanaging Cash flow is probably the biggest reason why both big and small businesses fail.  It is something you should be aware of and learn how to use it to your advantage. Yellow Belt 

Many people confuse cashflow and Profit thinking that they are the same thing. They are not and the difference is important to the financial viability of your business.

Cash Flow Defined

Let’s begin with a definition of Cash flow:

“The total amount of money being transferred into and out of a business effecting the liquidity of the business”.

In turn, “liquidity” means the ability to have liquid/available funds to pay the expenses of the business.

Cash flow slows down → liquidity slows down 
It becomes more difficult for the business to find the ready cash necessary to pay expenses as they fall due.

Liquidity slowdown is prolonged.
The business is going to have a looming survival problem.
It won’t have the cash to pay its bills, staff and the tax office.
It will need to either inject more funds of its own, take out an overdraft, obtain money from Venture Capitalists or give serious consideration to closing the business.
Cashflow is therefore a major determinant of survival.

To grow your business you will need cash.
That can come from either cashflow or debt; or a mixture.
Cashflow is therefore a major determinate of your ability to grow.

Oddly, you can make an accounting loss and still grow the business. Amazon reported losses for years but grew gangbusters.
It managed its cashflow such that it was getting paid by customers up front but paid its suppliers very slowly.
It had all that cash (known as “free cashflow”) kindly financed by its suppliers.  (see Cashflow Wizardry article)

While Amazon was doing this, it paid no income tax; because it was not making a profit.
Therefore, money that might otherwise have gone to tax went to growth.

Profit Defined

“Profit is largely an Accounting artefact which is meant to tell you how much money you have made during an accounting period (say a year).”

But it doesn’t tell you whether you have managed to collect that money from the people who owe it to you.

Profit can also be struck at several different levels of a business:

• Gross Profit – Total Income minus the Direct Expenses (often called the Cost of Goods Sold – COGS) associated with producing that Income.
• Operating Profit subtracts various Overhead Expenses, like Labour, Rent, Insurance from the Gross Profit.
• Net Profit further subtracts things that only Accountants love including depreciation and changes in valuations, goodwill and other so called ‘intangibles’.

Income – Direct Expenses (COGS) = Gross Profit – Overhead Expenses = Operating Profit

You can probably guess from the complexity of these multiple layers that Profit can easily be “fudged”.
Or you may be looking at the wrong figure when you are trying to determine how healthy the business is.

Even though you may have made a Profit, on which Tax needs to be paid:
If you haven’t managed to get that money from your customers.
If you have paid your suppliers too quickly.
You may not have the liquid/available funds to pay that Tax bill when it falls due.
This is despite that your accounts show that you are a Profitable Company.

There are different types of accounting that calculate Profit in different ways – Accrual and Cash Accounting.
We will not go into detail about these accounting systems here.

“Intangibles” may appear in your Profit & Loss Account.
These are called “intangible” because they are not cash.

Don’t worry if you get a bit puzzled about this.
They are included to show that profit is not a very good measure for the practical, day-to-day, management of your business.

Examples:

• Goodwill is an accounting evaluation which tries to measure, for example, the value of the Intellectual Property you may have in your business.
  It is a completely arbitrary figure.
  Intellectual Property in your business is what someone will pay for it.
  Very often the figures are arrived at through some very complicated accounting formula.
  
  
• Income from Capital Gains from the sale of some of your business assets.
  The Profitability is distorted because of the Tax treatments that are required.
  
  
• Depreciation is a theoretical reduction in the value of a Capital Asset, like a car.
  You could write off a business car, in your accounting, at a rate usually prescribed by your Taxation Office.
  It may be, for example, that you can write a car off in 5 years, meaning that it reduces in value to little or nothing in 5 years. However,
  We know that a vehicle could last a lot longer than that or be worn out well before the 5 years.

One of the problems with Profit as a benchmark for the health of your business: 

It can become stalled from flowing through the business.

Example 1:

Completed work can mount up as Inventory, yet to be sold in your business.
This will show as Profit: but it is not yet cash.
It will show as an Asset in your accounts rather than cash.
This gives you an artificial idea of your profitability – inventory can’t be used to pay the tax bill.

If your inventory is increasing, your profit will be increasing.
BUT your cash (necessary to pay your bills) will be reducing.

Increasing inventory should be a red flag to you.

Example 2:

The size of your Accounts Receivable (the money owed to you by customers).

If your Accounts Receivable is increasing, your profit is increasing.
BUT your cash goes down.

As soon as we sell a product, it shows as a Profit.
Until we bill it, and more importantly, get the money back, the Profit is artificial.

It is only when we have the cash that we know how we stand financially.

Perhaps the biggest indicator of the arbitrariness of Profit is the fact that an entire industry (tax accounting) has grown up to show the tax office minimum profit so as to pay minimum tax. It is a shaky concept to gauge the survival of your business.

Making the choice

Because your “Profit” is open to these sorts of manipulation, “Profit” is not a very useful guide to the day to day operation of your business.

Cash is very clearly either present in your bank account; or it’s not.

It really is an indisputable measure of your businesses ability to survive and thrive.

The calculation of Profit will be left to the accountants.

We will rely heavily on the estimation of cashflow.
This will give us reassurance that our business can pay its debts as they fall due and has the ability to grow.

Profit should not be read as “made” until it turns into cash.

Cash Insurance Policy

One of the most common causes of failure in both small and larger business:
They run out of cash to finance them through the inevitable downturns in their business/or economy.

At a high level, well known business writers like Jim Collins, suggest that his “Great” companies that he refers to keep between 3 and 10 times more cash reserves than their competitors. It is said that Bill Gates, from the very beginning of Microsoft, always kept at least a year’s worth of Operating Expenses in the bank.

In the Profit Autopilot article (see Profit Focused Business Model), a Profit target of somewhere between 10 and 15 percent is suggested.
Having this goal, and tuning the business and its Operating Expenses accordingly, means that there is money available when the inevitable downturns occur.

Resources

Measure cashflow accurately by using the Cashflow Conversion Cycle metric.

Refer to other articles on improving cashflow –  Cashflow menu.