One of the first things Accountants learn is that Profit is not Cash. I am not an Accountant and neither are most small business owners and this is an easy mistake to make.
For that reason I thought it might be helpful to do a post explaining the difference and how you can get from one to the other.
Always watch the Cash. You can run out of cash by over trading as well as under trading and remember, Cash is King!
Without going into the detail of how and why accountants organise Profit and Loss Accounts, it is important to watch the Cash and not the Profits. The whys and wherefores of all this is discussed below.
Any business has a financial floor below which it cannot fall without becoming insolvent. In essence it runs out of cash. If you make losses you can eventually run out of cash and the business will fail. What is not often appreciated, but is just as dangerous, is that you can trade too well and still run out of cash. I will try to explain how that happens.
The six factors relating to Revenues are set out below. At another time I will expand on each of these in more detail.
- Sales Units
- Cost of Sales
- Gross Margin
You need to have a detailed understanding of the key factors that drive your revenues and therefore be able to detect when they are rising or falling on a day to day, week to week and month to month basis. Once you can distill these factors into Key Indicators you need only watch these to understand how your sales are going.
Operational Costs – SG&A
The Operational Costs of a business or SG&A in US accounting parlance are all the costs which you need to run your business and deliver your products and services. These critically split between fixed and variable and you need to understand these and the difference between them.
It is worth watching your costs very carefully and understanding them opens the opportunities to make savings or to do things in a smarter way. I have set out the factors at the end of this section. Beware that from a cash perspective there will be timing differences month to month for things such as rent or bonuses and understanding the patterns of these cash flows is critical.
- Software as a Service
- Cost Management
Now lets look at the balance sheet and start with fixed assets. These are the assets which you purchase as part of your capital expenditure programme but can also include goodwill (arising from acquisitions) or capitalised assets (for R&D expenditure). These are depreciated or amortised through your Profit and Loss Account (but this is a NON cash item) – it just spreads a notional decline/expensing of these assets through the Profit and Loss Account over time. This reduces Profits (and tax) and is a very good example of why Profits do not equal Cash.
- Profit and Loss on Sales
- Lease or Rent?
The Working Capital of the company is reflected in the Debtors and Creditors in the Balance sheet.
This is the money the company needs to keep it running. Think about it like the oil in the engine rather than the petrol.
On a month to month basis, because debtors and creditors represent the balance at the end of the period, what we are interested in is the change from the previous month. This change represents either a “source” of cash or a “use” of cash and this distinction is critical.
Debtors – if your debtors increase, people owe you more money i.e. this money is in their bank account and not yours. Therefore an increase in debtors is a “use” of cash.
If your Debtors decrease, bills have been paid – Hurrah! This means money has come into your account and is a “source” of cash.
Creditors – This works the other way round. An increase in Creditors means you owe someone money but have not yet paid it. The money is in your account. Therefore an increase in Creditors is a “source” of cash. If your Creditors decrease, bills have been paid, a “use of cash”
The changes or delta in working capital are a critical part of understanding cash flow and whether your cash is increasing or decreasing and why. As an example, to explain overtrading, if you sell 1000 units of product at £100 a unit, you raise an invoice for £100,000. The invoice may be raised at the end of the month and not be paid for six weeks to two months after that creating a debtor and increasing debtors. This is a use of cash. However, you have to buy in parts for this and pay for them within 30 days settling bills and reducing creditors – another use of cash. You have to fund the costs until the invoices for the product is paid for – the timing difference between paying for the parts and being paid for the product. This is working capital.
- Short Term Creditors
- Long Term Creditor
- Sources and Uses of Cash
- Managing Peaks and Troughs
Time in all this is another critical factor. You need to watch your cash daily but anticipate its movements and your possible need for cash going forward. A monthly cash flow forecast allows you to do this and to anticipate sources and uses of cash over the year.
While some events are entirely predictable, some are not and you need contingency funds. Equally if you get a big order, what will this do to your cash flow – it will almost certainly flatter your Profits – such a deceptive Mistress!
Understanding how changes over time affect your cash flow helps you to understand the operational gearing in your business. How a change of X in Revenues will impact, not only profits, but also your cash flow.
Remember when constructing a cash flow model. Two things are critical. The model must not be circular and the balance sheet must always balance.
- Monthly and Annual
- Predictable Peaks and Troughs
- Unpredictable Events
- Operational Gearing
- Integrating P&L, CF and BS
Now we come to the real value in this process. If you can develop a financial understanding of your business, such that you know its characteristics you can use key indicators to measure and manage. You need to have some clear “drivers” of Revenues and your Operational Costs. You need to understand the impact of investments in fixed assets, particularly if you are using lease financing which will not appear in your Profit and Loss Account but will have a significant bearing on cash.
A clear understanding of the Working Capital Cycle and “Sources” and “Uses” of cash will help you to understand the state of your bank account, even when sales are going through the roof. All this brings you down to understanding your bank balance at the start of the month, your bank balance at the end of month and why it has changed. It will also, crucially, give you a chance of anticipating what is going to happen in the following months so that you can manage your Cash Flow Cycle.
A final word, if you look at your cash flow over 12 or 24 months on a graph it should look like a wavy line. The average of that line will give you some information. If the troughs of the waves are below your financial facilities, you are under capitalised and staying in business will be much harder. You can now work out how much additional “working capital” your business needs to trade and set about working out how you will either generate this cash or seek additional external funds from Banks or Investors.
- Revenue Drivers
- Operational Cost Drivers
- Investment Cycle
- Working Capital Cycle
- The Cash Flow Cycle
- Managing the Cash Flow Cycle
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