For a business to be successful, i.e. put money in its owner’s pockets, it is not enough that it be profitable, it must also be cash flow positive.
Image Cash Flows
Ever wonder why your business seems to be doing so well, I mean, sales are up and growing steadily, but still you struggle so hard to scrape up the cash to pay the bills? Or how about this, you seem to be doing alright, at least treading water, but then all of the sudden you realize that you have a lot of bills coming due, and soon? Where are you going to get the cash? Understanding cash flow and the process in how revenues become profits which become cash is one of the most misunderstood concepts for all small businesses and new business owners. After all, you say, if I’m out there selling sooner or later all that will take care of itself, right? Not so fast, McFlash! The successful business is both profitable and cash flow positive. Anything less is a sinking ship and you’re the captain that’s going down with it. So take a few minutes, read below, and see if it doesn’t help you understand how your business is milking the cash cow.
Understand the statement of cash flows
Recently I did a post on calculating cash flows which, even if you have an accountant and don’t ever plan on preparing your own cash flows, is a great primer on how every other item on the balance sheet effects cash flow. The basic equation is this: net profit minus any increase in assets plus any decrease in assets plus any increase in liabilities minus any decrease in liabilities minus distributions to the owner equals your cash flow for the period. Read this as an algebraic equations and think about its implications, the most important of which is this, profits are only one factor of many that determine your cash flow.
The Curse of Big Profits, or how you can have profits without cash flow
You’ve got a growing small business but still you struggle to pay the bills every month, never mind the big bills that come up every once and awhile like for replacing or adding necessary equipment or paying off the taxman. What gives? Well, go back to the equation and you tell me. Growing businesses often have cash flow problems because, in most businesses, you pay your expenses now and you get your money later. But not just your expenses, you are busy buying inventory and assets to put into production to meet your ever higher sales targets but the money that they generate can take months, even years, to find its way into your pockets. In your equation Net Profit – your increase in assets = little or negative cash flow. What to do? Most go out looking for loans or for other investors. A second option would be to keep your business lean by trying to make do with less and growing “organically.” Both have their pros and cons and the right answer depends on what you are most comfortable with.
The Robert Kiyosaki Strategy, positive cash flow, negative profits
The gloriously famous Robert Kiyosaki has won my heart for his constant exhortations to budding entrepreneurs
to become financially literate and to appreciate the value of cash flow. His classic example is the real estate venture, which can generate a positive cash flow but a negative profit, at least for tax purposes, due to depreciation on an asset that actually appreciates in value. The best of both worlds? Maybe. Look around where you live, are there any malls that have closed, neighborhoods that have fallen from favor, or vacant buildings that formerly housed thriving stores or businesses? Does real estate always appreciate in value? Now look at the cash flow formula above and think about which of those other factors might affect your cash flow. In a real estate venture it’s your liabilities, more popularly known as your mortgage. By increasing the life of the loan or by accepting a variable interest rate we can, in the short term, get a higher cash flow but at the price of higher overall costs in the form of interest payments. Don’t misunderstand me, the canny investor can still make a killing but she should keep in mind both positive cash flow and profits.
The Positive Cash Flow Now, Chapter 7 Bankruptcy Later Strategy, positive cash flow, negative profits
This is too often the fate of the new businessperson who is a very poor accountant and doesn’t believe it necessary to hire a good one. In the category of “I wish I had a dollar for every time I’ve seen this,” a new businessperson goes out and gets set up and some money starts coming in. They realize that to keep growing they will need to invest some cash, but they don’t have any, so they trot down to the local bank/pawnshop/loan shark and get some credit going. Some of the loan gets invested, some doesn’t and then this always happens. They don’t keep good records and frequently mix business and personal expenses and really only know how much money is coming in without keeping track of what is going out. They have idea if they are profitable but only know that they still have some cash available so hey, why buy that new big azz honkin’ SUV because we can deduct it for our taxes, right? The sad story comes to an end when Guido, their banker, gets nervous and wants his money back or when some big but unexpected bill comes do and they can’t pay it because the money is gone.
If you are serious about being in business, and if you just read through all this you must be, then you will want to really understand your cash flow and profit and how they interact. One excellent source I absolutely recommend is Steve Wilkinghoff’s “Found Money: Simple Strategies for Uncovering the Hidden Profit and Cash Flow in Your Business.” Steve may be an accountant rather than a preacher, but I jumped up more than once and let out a booming “Amen!” as I read it. Scared the hell out of the the people in the barbershop, but I got faster service because of it.
As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!
Tyler
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