We all run businesses to make money. So it is not surprising to find that two things become very important to entrepreneurs; Profit and Cash-Flow.
The big problem, however, is this; the two are very closely related and yet fundamentally different. You need Cash flow to run a business so you can make a profit.
But you do not need Profit to run a business. You will understand what I mean a little later on.
However, failure to understand the difference between profit and cash flow has been a major downfall for most small business.
And you can’t blame small business owners for confusing the two. Understanding the fundamental difference requires a certain level of basic, technical accounting knowledge.
Therefore it is crucial for any aspiring business owner to know that basic knowledge of accounting is a must when running a business.
There is simply no way you will be able to succeed as a business if you do not understand how your money works.
Off course you do not need to have a degree or national certificate in accounting to run a business. But just learn the ins and outs of basic bookkeeping and accounts, and you will be more than fine.
That being said, let us now look to explore the distinction between Profit and Cash Flow. This is very crucial and therefore you have to really pay close attention here. Let us look at each in turn.
Profit is money that you are left with after the deduction of all your costs and overheads from your business sales revenue. Notice here that I use the phrase money you are left with loosely.
Profit is money you are left with only in principle. That is because there is an accounting rule that says you should recognize a sale at the point of transaction, and not when the money is actually received.
Therefore as soon as you recognize a sale you have to include it in your profit calculations.
The problem, however, occurs when you have credit sales. As soon as you get an order, ship the product and raise an invoice for the credit sale, you have to account for it in profit and loss calculations.
This is before you even receive the payment for the sales. Therefore the key issue you need to understand is that within a Profit figure, there may be credit sales included, for which money has not yet been received.
This is the concept that therefore causes a lot of problems for businesses especially those with a lot of credit sales.
They may have high profits recorded on their books but because most of the money may not have been received yet, they tend to suffer if their debtors fail to pay for the goods or services.
You may describe turnover, and consequently, Profit as a typical representation of counting your chicks before they are hatched. As soon as your eggs are laid [Sales] you recognize them as chickens [Profit] right away.
Therefore in those businesses that sell on credit, it is more important to focus on building efficient debtor management systems than focusing on potential profit. Your Profit figure means nothing if you cannot collect on your credit sales.
Now let us look at Cash flow. This essentially represents money flowing in and out of the business. Cash flow analysis is only interested in cash and it’s movement within the business.
Your Cash is represented by the money that you have in your cash box and in your business bank account. Hence anything that increases your bank balance and your cash box is your inflow.
The main activities that increase your cash balances are cash sales, cash received from debtors, sale of business assets, overdraft available, any loans that you may receive, etc.
On the other hand, those factors which reduce your business balances represent your outflow.
Examples of things that suck the cash out of your business are rent and rates, wages and salaries or drawings, electricity, and gas bills, administration and distribution expenses, purchases, and all other business expenditure that may be required for the business to run smoothly.
So why is Cash-Flow so important?
Well basically without cash you can’t pay for anything. Simple! Cash is the blood that brings life to all parts of your business.
It is the fuel that keeps the business engine running. You run the business with Cash and not with Profit or Sales. It’s cash u need to meet day to day expenses and not profit or turnover.
As a business, you must make sure you don’t run out of cash. Without cash, you can’t pay for the items mentioned above. And failure to pay those is the same as buying a one-way ticket to business closure.
You will not survive without cash.
So In Summary
If you get nothing else from this article get this;
having profit does not mean that you have cash in the business
A lot of businesses profitable businesses get closed because they run out of cash.
Also not having any profit [incurring a Loss] does not mean you won’t have any cash available.
You can survive for years as a business while making loses but you cannot survive for 3 months, let alone one year without cash in the business.
My advice to all those wanting to start new businesses is that never sale on credit if you can help it. Selling on credit should be left to established businesses that can afford to write off bad debts, and are also able to invest heavily in debt management systems.
However if you can’t help it but sell on credit, then make sure you have a robust debtor vetting and management system in place to ensure that you collect your cash from those who owe your business effectively.
They were not lying when he said;
Turnover is vanity, Profit is sanity and Cash is King.