As someone who first qualified as an accountant, I tend to sometimes forget how difficult it can be for the entrepreneur to distinguish between profitability and cash flow. You can run a profitable business while running out of cash – and conversely you can experience positive cash flow, while your business slides inexorably towards a loss situation.
For clarity, by profitable we mean that total revenue exceeds total costs / expenses. Cash flow is positive if you’re taking in more cash than you’re paying out, and negative if vice versa. They are not always linked, which is one of the reasons why a proper accounting software solution is so important for a business.
Here’s a common example: a growing business that sells products, and is profitable (income exceeds costs / expenses), is cash flow negative. Why? Two reasons: firstly, as the business grows they need to increase their inventory levels, so they have a lot of inventory in their warehouse that they’ve paid for (cash out) but not yet sold. And as the business grows, so does the inventory level, and consequently the amount of cash tied up in unsold inventory. And secondly, they extend credit terms to their customers that are more favourable than the terms they get from their suppliers.
Consider the simple case of purchasing a product for $100, and selling it for $200. That’s profitable, right? But if you have to pay your supplier COD, while allowing your customer to pay net 30 days, then for at least 30 days, your cash flow is negative by $100 – yet you actually made a profit.
Conversely I’ve often seen project-based companies – such as software developers – under-estimate a quoted project, so that on a $100,000 project they make no profit. But they take a 25% down payment, and progress payments during the project, which for the first 70% or 80% of project duration keep the incoming cash ahead of their expense outlays (usually salaries). So until close to the end of the project, if you only look at cash, it looks like a good project. But if you correctly and accurately account for revenue and costs as they are earned and incurred respectively, then even halfway through the project, while cash is positive, you’d probably know you were in a loss-making situation.
Yet in my years as a vendor of accounting software solutions, I’ve seen so many entrepreneurial business forego accurate management financial statements, and simply manage the bank balance. Why? And what can we do to change this?