As an accountant for small businesses, the critical differences between cash and profits have been ingrained into your mind. You know that both profitability and cash matter to the health of a business. But your clients are focused on cash, and often ask you, “why doesn’t my cash match my profit?” This informational gap is all too common with advisory relationships—so how do you overcome it, once and for all?
When stripping away the numbers and translating the relationship between cash and profit to a language every client can understand, we are left with a simple analogy. Cash is the gas in the car that keeps everything running, and when our tank is empty, the car comes to a halt.
Speaking your client’s language is a good first step, but maintaining a healthy balance between cash and profits requires an ongoing conversation. The rest of this article, republished from LivePlan.com, will give you a step-by-step process that uses real-world examples and cash flow forecasting tools to make regular advisory meetings with your clients streamlined and efficient. Use it in real time with your clients, or send it to them as a resource, along with your monthly review.
In business, “the bottom line” gets all the glory. When people talk about the bottom line, they’re talking about a business’s profits. If a business is profitable, then everything is running smoothly, right?
That’s actually not the case. The number that really matters is how much cash is in the bank and whether a business is building up cash or losing cash. After all, if a business runs out of cash it will start bouncing checks and be shortly out of business.
The difference between cash and profits is an important distinction in business. Believe it or not, a profitable business can actually run out of cash. Fast growth can also lead to big profits, but no cash in the bank.
How can this be? Let’s explore the differences between cash and profits and find out.
How are cash and profits different?
Calculating your profit is pretty straightforward. In the simplest example, you take your sales and then subtract your costs and expenses to calculate your profit:
Profit = Sales – Costs & Expenses
But, these profits don’t necessarily equal cash in the bank. That’s because many businesses make a sale and then send an invoice to their customers, but don’t collect payment immediately.
When the sale is made and the invoice is created, the sale shows up in the accounting system and is counted towards total sales for the month.
Unfortunately, customers usually don’t pay their invoices right away. They often pay “net 30”, meaning that they’ll pay in 30 days. Sometimes, customers will take even longer to pay. And, until they pay there’s no cash in the bank even though the sale has been made and booked.
Here’s a real-world example:
Your business makes a $10,000 sale and sends an invoice to the customer. While you are waiting for the customer to pay, you have to pay rent, salaries, and utilities. The total of these expenses is $8,000. When you calculate your profit, your business will show a profit of $2,000.
$10,000 (sale) – $8,000 (expenses) = $2,000 (profit)
Even though your business is technically profitable, your bank account has $8,000 less than when you started the month because your customer hasn’t paid you yet.
Another key difference between cash and profits is that profits can be impacted by non-cash items. Depreciation, for example, reduces your profit but doesn’t have any impact on your cash.
How fast-growth can build profit and eat cash
If you read the history of Nike, you’ll be surprised to learn how the world-famous shoe company nearly went out of business time and time again as it grew. In the early days, despite fast growth and booming popularity, the company was perpetually on the edge of bankruptcy. How was this possible?
The answer is surprisingly simple. As Nike’s shoes became more and more popular, retailers would place larger and larger orders for shoes. Nike would have to fulfill those orders and they would have to pay their manufacturers to make and deliver the shoes. The manufacturers would require payment for the shoes up-front, while the retailers wouldn’t pay Nike until the shoes had actually been sold to customers.
So, while Nike showed huge profits on paper from the sale of their shoes to retail stores, they were perpetually on the brink of running out of cash because they had to pay to manufacture the shoes before actually getting paid by the retailers.
This kind of fast growth nearly killed the company several times over in the early years.
The timing of payments is the key to solid cash flow
To recap, sales and expenses are booked in your accounting system as soon as you create an invoice for your customers or receive an invoice from one of your vendors.
You use these numbers to calculate your profit.
But cash is a different story. Your cash is impacted by when your customers pay you, when you pay your vendors, and how much inventory you need to purchase in order to make a sale.
In the following video, you can see how changes in how long it takes customers to pay you, how long you wait to pay your bills, and how much inventory you keep on hand can impact your cash flow.
Forecasting cash is critical
Because cash and profits are so different and because cash is the lifeblood of your business, it’s critical to create a cash flow forecast for your business. With a cash flow forecast in hand, you can experiment with different variables to understand how to run your business best and keep cash in the bank.
Consider a cash flow forecasting tool
While you can create your own cash flow forecast, most people struggle with the formulas. Instead, try a business planning and cash flow forecasting tool like LivePlan. With a forecasting tool, you can work on your business instead of figuring out how to make sure all of your spreadsheet formulas are accurate and correct.
Noah is currently the COO at Palo Alto Software, makers of Outpost and the online business plan app LivePlan, and content curator and creator of the Emergent Newsletter.