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Why profit is not cash (the importance of cash flow)

June 10, 2010

One of the greatest challenges facing small businesses is maintaining a positive cash flow to enable the payment of debts when and if they fall due. The majority of small businesses fail within the first 12 months not because they are not profitable but because of limited cash flow.

Is it important to note that profit does not equal cash and conversely cash does not always equate to profit, however in the long-term they roughly equal out excluding leakages such as taxation and dividends.

Simple example:

You decide to start a business selling widgets. You decided to begin small and operate out of your garage saving yourself the cost of a rental premise, you also decide to utilize the resources that you already own such as computer, internet and stationery so far so good, no money down and you already have the premises and the basic infrastructure.

You start your business off by opening a business bank account and depositing $1,000 into it, bank fees are $5.00 per month,

Say an acquaintance of yours  is a web designer, so you utilize their skills as a favor at no cost to set up a web page to promote your business, however you must now pay an ISP to host your site and you also need to secure a internet address (domain) so that customers can find you. Lastly you need to purchase stock to sell. Initially you will only sell one type of widget.

So your expenses thus far are

ISP hosting $50 per month

Domain name $100 for 1 year

1000 widgets @ 75 cents $750

# all initial purchase are for cash as no credit standing with suppliers

So here you are the opening day and for less than $900 you are in business and still have $100 in the bank. This business operates on a 30 day credit terms for all debtors so although you have purchased the stock outright for cash, the economic realities of the widget business is that you need to offer 30 days credit to compete.

You will market your widgets for $1.00 each with a 5% discount for cash.

First week sales

You sell 750 widgets half are Cash on Delivery (COD) and the other half are on the 30 day credit terms.

So the first week sales figures give you the follow out come

Unit Price Total
375 1 375
375 0.95 356.25
750 731.25
Total Sales 731.25
750 0.75 562.50
Gross Profit 168.75

Wow now that looks good, but that’s gross profit you really need to look at the net profit for the bigger picture and you may ask yourself but I don’t have any other expenses but yes you do.

That garage your using, is it free to you, no it is not, so you should charge the business a rental for the use, the computers the internet access, your wife’s time and effort in setting up the Web Page all had a cost that should be reflected in the businesses P&L, as well as the start-up costs and ongoing expenses.

So you decide that the garage rental to be $75.00 per week. The computer is worth at least $1000 and that if you were to hire a web designer it would have cost at least $500.

So all up the business owes you $1,575 but how do you account for these especially since no money has actually changed hands? You need to invoice the business but allow open credit terms, i.e the business does not have to pay until cash flow allows. So let’s now work out the other expenses.

The computer is an asset and need to be depreciated over it useful life, it has an economic life of 2 years. The web design is really a non depreciable start-up cost that needs to be capitalized, call it goodwill so to speak it is an asset that forms part of the business.

Expense Annual Cost Life (weeks) Weekly Cost
ISP hosting 60000 52.00 11.54
Domain name 100.00 52.00 1.92
Computer 1,000.00 104.00 9.62
Office 3900.00 52.00 75.00
bank fees 60.00 52.00 1.15
Total 99.23
Net Profit 69.52

So in the first week you have made a tidy little profit of $69.52 so lets see how this equates to the actual cash the business has in the bank after all you need to buy more stock and pay your self.

O/B Bank 1,000.00
Less Purhases
Stock -750.00
Domain Name -100.00
ISP Hosting -50.00
Bank Fees -1.15
Total -901.15
Cash Sales 356.25
Total 356.25

So after the first week the bank account is $455.10, now assuming that you will at least equal last weeks sales the following week you would need at least $750 to replenish the stock to sustain the current sales level.

Note that you still won’t be paid for the credit sales for at least the next 3 weeks. So already it’s week one and will be actually overdrawn by at least $300.00

So the issue here is that the business was profitable but cash flow lags the actual profitability. To sustain the start-up you would need to allocate at least $3000 to be able to pay all the bills until at least receipts from the debtors start to be paid. In time you will be able to obtain credit for inventory purchases from your suppliers, however as the business expands larger premises may be required that will require a monetary outflow, also as sales increase you will still need to finance the acquisition of more stock and this needs to be paid for by either profits (reinvesting in the business) or debt that carries the additional finance costs.

Bottom line is just because you are making money does not mean you have any money, most of it is tied up in assets, inventory and debtors, when making any decisions to purchase assets a clear knowledge of future outgoing’s is necessary.

All advice presented here is of a general nature and no guarantees as to the relevance of said advice to your circumstances is implied, please seek professional accounting advice prior to making any decision regarding the above information


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