Understanding your finances helps you build a legacy by creating a profitable business that not only thrives today but leaves a lasting impact.
It’s a common scenario for many business owners: your accountant shows you’ve made a profit, but when you look at your bank balance, it tells a very different story. How can this be? Let’s break down some of the reasons why your profit and cash flow might not be in sync.
1.
Timing Differences
If you run a cash based business, i.e you get paid as soon as you've made a sale, this issue of a timimg difference won't affect you. If you give your customers time to pay, read on, this is crucial to understand.
Profit is recorded when income is earned and expenses are incurred, not when the cash actually changes hands. For example, if you invoice a client in December for work done but they don’t pay until January, your profit for the year to December includes that income, even though the cash hasn’t arrived yet. Similarly, expenses that are incurred in one period might not be paid out until later.
Speed up the time it takes to get paid and get your hands on the cash.
2.
Outstanding Invoices
If you’re offering credit terms to your clients, there could be a significant delay between when you make a sale and when you actually receive the payment. Your profit and loss statement shows the sale as revenue, but until that invoice is paid, it’s not cash in the bank.
3.
Large Capital Expenditures
Sometimes, your business might need to make large purchases, like equipment or vehicles. These expenses can eat up your cash flow, even though they’re recorded differently in your financial statements. These purchases are often considered capital expenditures and spread out over time (depreciated) rather than being fully deducted from profit in the period they’re purchased.
4.
Loan Repayments
Loan repayments are another common reason for cash flow discrepancies. While only the interest portion of a loan repayment affects your profit and loss statement, the full amount of the repayment, including the principal, impacts your cash flow. This means that even though you’re profitable on paper, loan repayments can drain your available cash.
5.
Inventory Build-Up
If you’re buying or manufacturing more stock than you’re selling, your cash is tied up in inventory. While this might position you for future sales, it can create a cash crunch in the short term. The cost of inventory impacts your cash flow, but it doesn’t affect your profit until the inventory is sold.
6.
Paying Off Old Debts
If your business is paying off old debts or liabilities, this won’t necessarily show up as an expense on your profit and loss statement, especially if the debts were accounted for in previous periods. However, these payments reduce your cash balance.
7.
Profit vs. Cash Flow
Finally, it’s essential to understand that profit and cash flow are two different financial metrics. Profit is your income minus expenses, while cash flow represents the actual flow of money in and out of your business. A profitable business can still face cash flow problems if its cash inflows don’t align with its outflows.
What Can You Do?
To avoid the stress of having no cash in the bank despite showing a profit, here are some steps you can take:
- Monitor Your Cash Flow Regularly: Keep a close eye on your cash flow statements to understand where your money is going and coming from.
- Improve Your Invoicing Process: Encourage prompt payment from clients and consider reducing credit terms.
- Manage Inventory Wisely: Avoid overstocking and try to balance inventory levels with sales.
- Plan for Capital Expenditures: Spread out large purchases when possible, and consider financing options that don’t deplete your cash reserves.
- Create a Cash Reserve: Building up a cash buffer can help you cover expenses during lean periods.
Understanding the difference between profit and cash flow is crucial for making informed business decisions. By taking proactive steps, you can ensure that your business remains both profitable and liquid, avoiding the stress of a healthy profit on paper but no cash in the bank.
Your Financial Ally x
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