Cash flow has nothing to do with profit.
Making a profit is the most important job you have as a business owner. Working to make a profit when you don’t have available cash is like playing football without ever getting to play offense. Your only chance of a score, and small at that, is when your competitor makes an error. You’ll never win the game this way.
How can a business have profit but no cash flow? Unfortunately, it’s too easy to get into this position, and most of the time it’s because a business has
- too much debt service (loan payments)
- customers who do not pay on time or at all
Other reasons why a business may have profit but no cash in the bank are:
- unexpected cash expense for equipment replacement
- spoiled or damaged inventory
- personal financial emergency
Below is an example of this happening to a business that sells products.
Here is your August Profit & Loss that shows a profit.
- Sales on account (you bill the customer and they have 30 days to pay you) $15,000
- Less Cost of Goods Sold ($4,500)
- Less Overhead [payroll, rent, insurance, etc.] ($7,000)
- Equals Profit $3,500
Here is what happened in your bank account.
- Balance on 8/1/16 $1,000
- Less rent paid on 8/1 ($2,000)
- Plus bank deposits from customers paying their July invoices $10,000
- Less payroll 8/15/16 ($2,000)
- Less other overhead expenses ($1,000)
- Less payroll 8/31 ($2,000)
- Less loan repayment ($1,500)
- Less inventory purchase ($3,000)
- Equals overdrawn bank account ($500)
There were three things above that drained your bank account but do not figure into August's profit:
- You made $15K in sales in July, but only ⅔ of your customers paid on time.
- Loan payment of $1,500 drains cash but it's not part of monthly operating expenses when calculating profit.
- Inventory purchased that will be sold in September. Inventory is only expensed on a Profit & Loss when it's sold.
If you had collected all of your July sales on account in August, you would have $4,500 in the bank, all your bills paid and enough inventory to sell in September. Another way to avoid the bank overdraft would be to finance your inventory purchase and pay it off as soon as possible in September.
Managing cash is just as important as making sure you make a profit each month.