A very typical conversation I often have with business owners in the discussion of profit and cash flow usually goes something like this…

Me: “You’ve made $xx profit this year and your tax bill is $yy.”

Client: “But I can’t have made that much profit, cash flow is so tight I struggle to pay wages some weeks. Where am I supposed to find money to pay that sort of tax bill?”

One of the fundamentals of business, but so often not understood, is that profit does NOT equal cash flow. But managing the relationship between them is crucial to business survival. It does not matter whether the business is big or small – if cash flow is poorly managed the consequences can be devastating.

And don’t think that, just because your business is profitable, you don’t need to keep a close watch on cash flow – many profitable businesses have been brought to their knees because of cash flow problems.

How does this work?

What you record as ‘profit’ is essentially the difference between sales and the costs incurred to generate those sales within a specified period, e.g. a month or a year. ‘Cash flow’ comes into this process if you have recorded a sale and delivered the goods or service but you have not been paid by your customer (because it is customary in your industry to offer credit terms as an inducement to do business which gives rise to accounts receivable or debtors). In effect, you have made a sale and made a profit – but you don’t yet have any cash! While you wait to receive money from your customer however, you must continue making payments to suppliers for inventory, to employees for wages, to financial companies for repayments on equipment, and so on. The longer your customers take to pay you, the worse your cash flow situation becomes.

Sales, costs, and profits, do not necessarily coincide with their associated cash inflows and outflows. The net result is that incoming cash receipts often lag behind the outgoing cash payments and, whilst a profit may have been made, your business could still be experiencing cash shortfalls. This shortfall is often referred to as your working capital requirement.

This situation can have two very serious consequences for your business – at best, a slowing in the rate of growth in your business; at worst, complete business failure as suppliers exert pressure for payment of monies they are owed. Rapid growth by profitable businesses can often lead to shortages of cash, because extra money is needed to finance expansion (for example to buy extra stock or purchase equipment). There is an immutable law in business that, unless collection activities change to bring in more of the cash owed to the business, growth in sales must result in increased accounts receivable. This means that if cash flow is already tight in your business, chasing more sales may actually be the WORST thing you could do!

Good financial management and having a plan to manage cash flow will reduce the likelihood of an undesirable disruption to your business. The plan should revolve around implementing effective business practices for improving cash flow and using a cash flow forecast mechanism to predict and manage periods where cash is expected to be tight.

How do I avoid the pitfalls?
Good practices for ensuring cash flow continuity

1. Manage the credit you give – if you can’t avoid giving credit at least develop policies and procedures to ensure credit is only offered to reliable and profitable customers…and follow them diligently! A good credit policy starts with an application process that collects information about the customer to help you assess their credit worthiness. Ensure that customers know your credit terms and be consistent in enforcing them. Charging interest on late accounts is remarkably effective.

2. Keep your books up to date and invoice regularly – if your books are not up to date how do you know what money you are owed or if an amount has become overdue? Without accurate books your cash flow forecast and other reports will be worthless and the benefits of forecasting will be lost.

3. Have a contingency plan in case you need to borrow money at short notice for unexpected crises in cash flow – the most common source of short term funds is the owner’s personal cash reserves, assuming there are some. It is far better to be prepared than to have to arrange finance on unfavourable terms at short notice.

4. Manage your accounts payable – don’t pay early unless good discounts apply, as that consumes cash you could be using to earn interest or investing elsewhere. Similarly, don’t pay late as that puts suppliers, who you might need to carry you over an emergency, offside.

5. Fund your business properly – know what your working capital needs are and ensure you always have sufficient working capital available. Ensure that any outlay on capital equipment is matched by long term funding such as a term bank loan or a hire purchase agreement over a number of years. That way, the cash outlays are timed to coincide with the expected cash inflows to be derived from the investment in the fixed asset.

6. Keep inventory to the minimum necessary – if you can decrease the amount of stock you are holding without decreasing your sales, then you have less money tied up in stock which releases cash into the business for other activities.

7. Keep personal drawings to a minimum – the single largest contributor to businesses failure is excessive personal drawings.

8. Understand your tax obligations – know what you owe and when it is payable so your cash flow doesn’t suffer.

Forecasting profit – knowing and planning for the peaks and troughs of cash flow

For many business owners, budgeting and cash flow planning is akin to crystal ball gazing. For that reason many can’t see the point in doing it. Yes, it is difficult but the more you do it the better you become at it. Your cash flow needs constant monitoring and review using a cash flow forecasting tool to make sure you always have enough ready cash to meet your obligations on time.

Profit and cash flow are two factors that do not necessarily go hand-in-hand. More businesses fail from poor cash flow management than from the inability to make a profit. If for no other reason than that damning statistic, it is essential to manage the procedures that determine cash flow and to forecast the cash flow situation so you can be aware of when cash shortages may be looming.

Good cash flow management doesn’t just happen! It is a combination of having the right procedures in place and ensuring they are consistently observed. Both your accountant and your business advisor can help by looking at your current processes, recommending changes that will improve your cash flow and providing you with a regular cash flow forecast.

With proCFO you have all the benefits of your own CFO without the significant cost of a full-time employee. We provide you with accurate, understandable and up to date financial data, giving you the confidence to make the right decisions for your business. We are the market leaders in virtual CFOs, so let us take the stress out of your financial management. sing our innovative cloud based system, we will bring you the latest in financial administration services delivered with flexibility and a custom designed approach.

About David Officen

David Officen

proCFO Founder and Managing Director

David is the Founder and Managing Director of proCFO. David combines an accounting and consulting background with commercial experience both as a manager for large commercial businesses and as the owner of private and family businesses.


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