Cash vs ProfitSadaf Abbas
Does a profitable business guarantee favorable cash flow? The answer is, “No.” You may see naive entrepreneurs emphasizing the bottom line. This bottom line is profit. However, profit does not always translate into cash. What primarily matters is the amount of cash in the bank. The cash numbers are usually taken from Financial Statements or Financial Modelling.
A business should be building cash instead of losing it. It is because if it runs out of money, it will face bouncing checks. In a nutshell, it will shortly run out of business. A successful entrepreneur can distinguish profit from cash.
Differentiating cash with profit
To calculate profit, a firm subtracts all the cost of goods sold and operating expenses from its revenue.
(Cost of Goods Sold)
It is hard to believe, but a profitable business may run out of cash. For instance, if a company sells most of its stocks on credit, the books will show high profits due to more sales. However, the cash in the bank will not increase. If this goes beyond a specific limit, a business may collapse.
When you sell something to a customer, it is posted to the sales ledger in the books of prime entry. Therefore it is counted in the monthly sales total. But the customer usually takes 25 to 30 days to pay. Businesses offer cash discounts to their customers to encourage prompt payments from customers.
The cash or bank account of the company is impacted when any customer makes the payment when you pay expenses or order inventory from suppliers. To keep a favorable cash flow, you are advised to defer your expenses or inventory payments as much as possible. On the other hand, encourage customers to make prompt payments by offering them cash discounts.
Let us look at a numeric example:
If your business makes a sale of $20,000, your profit and revenue will be up by $20,000. But your customer will pay in 15 days. Meanwhile, you have to pay for your utilities like rent, electricity, gas supply, salaries, etc. These utilities total $5000, so your accounts will be showing a profit of $15,000. Despite this handsome profit, you had to pay the amount from your pocket. Assume if you did not have enough cash to pay them. You would have defaulted on your payables.
Similarly, your profit is also impacted by non-cash items such as depreciation, stock-based compensation, impairment loss, and amortization, which do not affect your cash.
The dilemma with fast-growth
When a company becomes popular, retailers place orders in larger quantities. So the company orders an increased quantity from the suppliers who will require payment for the merchandise up-front. On the other hand, the retailers will purchase the product of credit and pay back the company once they sell them to the consumers. This dilemma of fast growth nearly took a giant like Nike out of a business couple of times. Despite booming popularity, Nike perpetually went on the edge of bankruptcy.
Forecasting Cash Flow
In conclusion, it is critical to forecasting the cash flow of your company. It is because cash is the lifeblood of any business. When you have a budgeted cash flow in the hands, you can evaluate your business and the average money it requires per month by experimenting with the variables.
We, at Oak Business Consultant, are specialized in providing consultation on these matters. We have helped some companies in building a robust financial model and business plan along with Pitch Deck. Therefore, you can visit our website Oak Business Consultant to consult with us for free.