The 1 thing every entrepreneur should understand about cash flow
If my income statement shows that I’m profitable, why don’t I have any cash?
I get this question all the time from entrepreneurs. The simple answer is that profit does not equal cash flow. While the answer is simple, the concept itself is a bit more complicated. Let’s break it down.
Cash flow is defined as the net amount of cash going into and out of your business: cash receipts minus cash disbursements. Cash flow measures the overall liquidity of an organization. Net profit is defined as your revenue minus your expenses and measures the longer-term sustainability of the company. Both are simple concepts and both are very important measures of the health of a business.
While they often move in the same general direction over time (i.e. increases in profitability signal an increase in future cash flow), they are not the same. It is important for a business owner to understand some of the more common reasons why cash flow gets delayed.
- Investing in inventory – This is a big one. Companies that must carry inventory as part of their business model are particularly susceptible to swings in cash flow as they purchase and then subsequently sell their inventory.
- Paying your bills before you get paid by your customers – Almost every business falls into this category. It is very common to have to pay certain expenses before you can produce goods or services and get paid by your customers. Typical front-loaded expenses include payroll, supplies, inventory, sales & marketing expenses, etc… This is why start-ups have to come up with a certain amount of working capital in order to open for business.
- Extending credit – This is related to the last point. Whenever you extend credit to your customers, you are delaying your cash flow. While there are certain industries that have to extend credit in order to do business, this is an area that I like to challenge. Changing your cash collection model can make a massive difference in your cash flow. Challenge the status quo and see if you can collect via ACH or eCheck and eliminate the collection period. This will result in a permanent pick-up in cash flow.
- Investing in equipment – Sometimes in order to grow your business, you have to invest in new equipment. While this is probably a good decision in the long term, it will require cash and potentially put a strain on the business.
- Repaying a loan – Let’s say you took out a loan to buy that equipment you needed for the business. The repayment of that loan will also be a use of cash. However, using debt to pay for capital equipment is a good way to ease the cash flow burden. The benefit you receive from that equipment will occur over an extended period of time. By taking out a loan you are also extending the cash payments and more closely matching the cash flows.
- Prepaying an expense – Annual license contracts are pretty common these days. Most SaaS companies offer or, in some cases, require an annual payment. You are paying the entire amount upfront, but receiving the benefit and expensing it on your income statement over a twelve-month period.
Companies that are growing may experience several of these at the same time, which is why those business owners feel like they are always running low on cash despite being profitable.
Cash is the lifeblood of any organization. At Milestone, we are cash flow experts. Whether you are trying to confidently forecast your cash flow, or you are looking to implement best practices for cash flow management, we are here for you.
Give us a call at 317-810-0165 or email us at firstname.lastname@example.org.
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