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Profit Doesn't Equal Cash: Understanding Profit and Cash in a Small Business

I recently met with a business owner in Nashville.  We met at a place for breakfast and as the coffee arrived she got straight to the point.  She pulled out her P&L statement, pointed to the six figure Net Profit and said "I can't find my money!"  Without fail, this is one of the most common frustrations expressed by small business owners during our initial meetings. They're showing a profit but have little to no cash.  How does this happen? Let's dig in...

The Difference between Profit and Cash:

It's extremely important for small business leaders to understand the difference between Profit and Cash Flow.  In the spirit of keeping this short, revenue is reported when sales are made.  Expenses are recorded with the corresponding revenue.  Your Profit and Loss statement will show Net Profit to illustrate the net income after all expenses are deducted from all revenues in that period.  Cash Flow, on the other hand, is the net balance of cash moving into or out of the business during the same period.  So what do these tell us? The simple answer is that Profit shows the ongoing sustainability of the business while Cash measures the company's ability to pay its bills.  What you need to know is that it is totally possible to show profit but no cash or to show a loss but have positive cash flow during a period.  

Finding the Money:

So you're running an operation that consistently shows a profit but has little to no cash?  The answers can be found on the balance sheet. You'll find your cash in multiple areas including inventory and paying down debt like loans and/or credit cards.  You'll need to gain a basic understanding of all the ways Cash moves out of your business but is not shown on the P&L.  There are several activities that can contribute to a period showing profit but negative cashflow.  Here are a few:

• Buying inventory - If you buy inventory that is not sold in the same period, Cash goes out of the business but the Cost of inventory won't be shown on the P&L until the items are sold
• Allowing customers credit or giving them extended payment terms - If you close a deal for $5k but the customer doesn't pay until 45 days later, the sale will be recorded this month but the cash will not come into the company until due.
• Repaying a loan - Only interest payments are allowed to be recorded in expenses on the P&L. While interest payments are shown on the P&L, principal payments aren't and therefore lower the cash account but do not effect Profits.
• Prepaid Expenses - Let's say you pre pay Rent for a year (I hope you got a good deal). All that cash leaves your business now but your accountant will still likely record monthly rent amount each month on your P&L.

Lets Look at a Real Life Example:

Sharon's business had $50,000 of Revenue for the month of October (For the sake of simplicity, we'll assume she has no Cost of Goods Sold and her Gross Profit is $50,000.) Her expenses were $25,000 and she's showing a Profit of $25,000 on the bottom line. During the month of October Sharon's business bought $15,000 extra inventory for the holiday season and made a big $10,000 principal payment on her business loan.  And just like that Sharon shows a $25k profit but has no cash.  Sharon's cash is on the shelves in the form of extra inventory on hand and in her banker's pocket. Well, not literally but you know what I'm saying here. Profit doesn't equal cash for Sharon!!

Breaking even or Making Profit?

The biggest mistake Small Business owners make when planning their year, setting goals, or finalizing decisions is failing to understand their true cash breakeven point.  While you may hear people discuss breakeven point regularly, you'd be surprised at how many people calculate Breakeven point based on the P&L but fail to consider the additional cash flowing out of the business month to month for balance sheet items. Once you know your true cash breakeven point, you'll be able to see how any changes in Sales, Margin, or Expenses can raise or lower your breakeven point.  For example, if you do the same sales volume with a better margin and/or lower expenses, you'll breakeven earlier in the month and realize true cash profit on any sales past that point.  

And Here It Is! If you want to create a sound financial plan for your small business there are three major steps to take:

       1. Find your True Cash Breakeven Point

       2. Create your Revenue and expense plan for the month, quarter, or year. You need to think through basing your goals, compensation, staff incentives, decisions around the true cash breakeven point.

       3. Find your Performance to Plan Process.  You need simple tools to allow you to see on a weekly basis how your business is performing vs. the financial goals.

Remember our breakfast friend? We still work together on ongoing improvements but I'll tell you one thing for sure....She knows where her cash is!

If you need help getting started with step one, find our free tool below.  As always, if you need any guidance feel free to Contact Us any time.

GET OUR SIMPLE TRUE BREAKEVEN CALCULATOR FOR YOUR BUSINESS!