Varying Degrees of Balance

Here are some observations about how profit and cash flow can exist in varying degrees of balance when you make financial projections for your business:

  • By definition, profit (also called net income) is the surplus after all expenses are deducted from revenue, and it is the basis on which tax is calculated. On the other hand, cash flow is the amount of available cash within a business at any given time as a result of the inflow and outflow of money.
  • High profit & low cash flow results in a profitable business unable to pay its bills. How can this happen?
    • If the product you’re making is selling for a higher price than what it costs to manufacture, you have a profitable basis for a business. However, the devil is in the details.
      • Many wholesale customers hold invoices for up to 120 days before payment — meaning you may make the sale and deliver the product, but not get your money quickly.
      • If your material suppliers demand payment on delivery of goods, that’s a gap of up to three months after you pay suppliers but before receiving payment from your buyers.
      • So, even though you are making a per-unit profit, you may be unable to meet your financial obligations during those lean three months while you wait for your invoice to be paid. In a worst-case scenario, this situation can send a profitable company into bankruptcy.
  • Cash flow rises & falls with revenue growth & the strength of management. Revenue growth alone doesn’t necessarily boost cash flow. Revenue can go through the roof, but if overhead goes up faster, cash flow suffers.
    • The four significant factors that have a negative impact on cash flow:
      • Falling margins
      • Slower collections
      • Swelling inventory
      • Paying suppliers too fast
  • Just because a business can pay all of its bills doesn’t mean it is profitable.
    • If you’ve borrowed money to solve a cash flow problem, the increasing debt on that loan could cause your per-unit cost to exceed the break-even point, and your business will no longer be profitable even though you have cash on hand.
    • You could also experience increases in production volume that might cause costs to rise above a profitable level.
  • Growth costs money, and if you suffer from negative cash flow, your growth will be stunted even when there is strong market demand.
  • Regardless of how great your product or business model is, you will not survive if you cannot manage your company’s cash. Small-to-medium businesses are at highest risk of being “cash poor” because they constantly re-invest profits into the operation. Larger, more established businesses frequently have a cash reserve.

If you liked this thought, you may enjoy the free video The Financials – Managing Your Business Session 1 Understanding Key Concepts.

Copyright ©John Trenary 2019

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