Profits Are Good … But, Cash Is KING!

Cash is the tool that keeps your business running smoothly.

Have you ever heard this one: “I do not understand why (insert business name here) went out of business. They were profitable.” I am starting my 45th year of consulting with businesses and over this period of time, I have observed many shops that showed a profit on their financial statements but did not have enough working capital (cash) to run their operations.

To understand why profits and cash are two completely different items, you have to understand basic accounting principles. A profit and loss statement is a “snapshot” of your business for a specified period of time. Since financial statements are providing the business owner with a snapshot of the amount of sales and expenses that were realized during the specific period of time, but the statement does not take into consideration account receivable and payables. As far as the financial statement is concerned, all of the revenue booked during the specified period and all of the expenses booked during that same period were taken in and paid out. The difference between what was taken in and paid out is either profit or loss. If the business had a profit of $10,000 for the month and also had payables that had not been paid at the end of the month of $20,000, its cash flow would be negative $10,000.

Payables and receivables are accounted for on the balance sheet. The balance sheet accounts for the business cash position from the day it started until the day the balance sheet is run. The balance sheet includes all of the corporation’s debt, both long term and short term, as well as its depreciation.

Let me give you a real world example: I have a client who had a very successful body shop. His financial statement showed an annual profit of more than $150,000 for the first year in business. This owner decided to open a second location in a different part of town. The second location was financed with the profits from the first location. The owner purchased the building for the second location and financed $150,000 in new equipment.

His monthly fixed cost for the building and equipment was $15,000. He hired a manager, receptionist/bookkeeper and an estimator. He also had three metal men and a painter, all on salary. When you factor in variable expenses for utilities, phones, computers, software, etc. his average monthly expenses were around $75,000. The business lost money.

For the first five months, it averaged losing $25,000 per month. The next eight months, it was close to breaking even each month. The manager and the receptionist/bookkeeper did not do as good of a job managing their receivables as the owner did. At the end of the first year, the shop had more than $100,000 in receivables on the books.

The profit and loss statement for the second location shows that the business had a loss for the first year of $125,000, but the cash flow for the same period showed a negative cash flow of $225,000. The business owner’s first shop had a profit for the year of $150,000; take out taxes of 30 percent and he has $100,000 to invest in business No. 2. If the owner does not have access to another $125,000 in cash from his savings or the ability to borrow $125,000 from a bank, both businesses may be in jeopardy of going out of business.

Cash flow is the amount of cash your business has available for operations. Cash flow projections tell the business owner how much cash will be available for operations over a pre-defined period of time.

The formula for cash flow is cash on hand plus cash in the bank plus current receivable (receivables due in the next 30 days). Cash flow equals cash available minus current payables. Current payables include accounts payable (within the next 30 days) plus payroll and payroll taxes due in the next 30 days. The difference between cash and payables is called “cash flow.”

Caution: If you are relying on the cash flow forecast report that is found in most small business software programs, you must make sure that the report is picking up payroll projections. I mention this because many small businesses use an outside service to handle their payroll. If you are using an outside firm, then your in-house software program may not be picking up “projected” payroll because your bookkeeper only inputs payroll after the outside company has sent the bookkeeper a bill for payroll and taxes. Your system only counts the cash out. This bill shows up on your balance sheet as a bill entered and paid on the same day. Since the bill is entered and paid on the same day, most software systems only look at payables that have been entered into the software as due in the future. If payroll is put in as due and paid in the same day, then your system does not pick this up. It does, however, show that your cash decreased by the amount of the payroll.

I have found that the best way to manage cash flow is to look at it every week, then plot it in an Excel spreadsheet with a graph so you can see changes over time. To do this, you need to print out a balance sheet for your business weekly. On the left side of the balance sheet, add up your cash on hand plus your cash in the bank. This equals cash available, then subtract payables due – be sure to include credit cards, payroll due and taxes due. The difference is your cash flow.

Sample weekly tracking report:

12/18/2013 $23,805

1/10/2014 $19,771

1/22/2014 $3,045

2/02/2014 $11,968

2/12/2014 $17,078

3/06/2014 $74,242

3/14/2014 $27,883

3/27/2014 $72,232

4/09/2014 $47,607

4/18/2014 $19,435

5/07/2014 $2,000

5/29/2014 -$ 3,800

6/26/2014 $35,245

How much cash should you have on hand? First, remember that cash is merely a tool, just like the wrenches you use to repair a vehicle. Cash is the tool that keeps your business running smoothly. Too much on hand is like having an expensive tool in your box that you never use. Too little on hand is like having a worn-out tool, one that will get the job done but, because the tool is inadequate, it takes a lot longer to get the job finished. How much cash flow your business has will vary greatly, depending on the life cycle stage your business is in. Young businesses never have enough cash, mature businesses have too much cash that goes to waste because it is not being used.

It is not how much cash your business has on hand that is important. The most important thing a business owner needs to know about cash is how much do I have now, and how much will I need over the next 30, 60, 90 days? Is the cash that my business has being put to its best use?