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Profit V Cash

Why am I profitable but have no cash?  
In the 22 years I have worked with small and medium business’ owners, managers and team members I have observed with great interest what they do and don’t understand about business finances.
From my observations I believe one of the most common misunderstandings is that of the difference between profit and cash flow.

Before working in my current role, I worked as a taxation accountant and consultant. When meeting with a client to discuss their tax position, the conversation would go something like:
‘Mr & Mrs Client, congratulations to you on a successful year. You’ve made a profit.’
At this point, Mr and Mrs Client’s jaws would drop in unison. ‘But how could we have made that profit? That money doesn’t exist in our bank account! That can’t be right. And now you’re suggesting we’ve got to pay tax on that profit. How are we supposed to pay when the money doesn’t even exist?’
Does that story sound familiar to you or someone you know?
Understanding the difference between profit and cash in my view is absolutely critical. It often explains why great businesses that are profitable go broke.
It also explains why some business owners seem to be rolling in cash, never having to worry about how they are going to meet their financial commitments.
What is the difference then? Why is it that your profit and loss report is saying that you’ve made a profit, but it is not translating into an abundance of cash?
The answer to this lies in five areas. In other words, there are five places that your profit goes into:
Capital expenditure – when you buy a desk, a chair or even a laptop computer it’s unlikely you’ll borrow to make those purchases, because the dollar amounts for those individual items are too small to justify debt financing. When you add up all of those purchases over a given financial year the total can become a material amount out of your profit.
Debt repayments – if you have debt of any kind in your business, it must be repaid. Debt is repaid from your profit. No profit means great difficulty in repaying debt.
Drawings / dividends – if you take a drawing or divided from your business, this also comes out of your business’s profit.    
Income Tax – if you’re making a profit, you’ll be paying tax. 
Working capital – if your business’s turnover is growing, then the amount of dollars tied up in working capital will grow also. Also, if you’re not managing your working capital well, this will also have a negative effect on your cash flow. Let’s take a simple example. If your accounts receivable at the end of last year was say $150,000 and your revenue grew this year. Let’s say your accounts receivable went from $150,000 to $250,000. This means an extra $100,000 is tied up in your working capital. This comes out of your cash flow.
So there it is: The five areas that take up your profit. 
If your profitability exceeds the sum of those five areas, you will have positive cash flow. Conversely if those five areas in your business add up to more than your profitability, you will have negative cash flow.
In accounting speak, these five areas is known as the funding of your business. How well is your business funded?
The best way to get control of your business’s funding is twofold: 
Firstly develop an understanding of your business’s funding requirements in the form of a plan. Research your business’s funding needs and document it into a plan. Create a capital expenditure budget, build a debt reduction plan, know what your dividends are going to be, talk to your tax accountant about your likely tax payments for the year, and build an understanding of your working capital requirements. 
The sum of these items can then be matched against your expected profitability. Does the sum of those five areas for you exceed your expected profitability? If yes you’re funding is not balanced and you will experience negative cash flow. 
If that is the case, you have a couple of options. You can either improve your profit to match or preferably exceed your funding needs. Or go back to the drawing board and see if you can reduce the five funding items to match or be less than your expected profitability.
All of this can be put together in what I call a Financial Strategy Plan. Now is the perfect time to be putting a plan like this together since the new financial year is just around the corner.
Secondly and just as critical – monitor. A business is either going to be on track or off track when it comes to its plans. You must be clear on how your business is tracking to be able to keep it on track. It’s like driving a car. Would you drive with your windscreen painted black? You simply could not tell if you we’re on track or off track.   
A proper management reporting system will give you the ability to monitor effectively.
By paying attention to these critical financial aspects to your business, you will improve the funding of your business. In non-accounting speak this simply means your business will become constantly and consistently cash flow positive.
How does that sound to you?
By Greg Smargiassi

Posted on May 21, 2013

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