Profitable Business - Cash Is King And Profit Is Why You Are In Business
When you are trying to sail towards a destination that is directly upwind, the priority in yacht racing is speed first, then aiming your boat as close to the wind direction as possible. It is better to sail slightly further at higher speed than it is to sail the shorter distance at slower speeds towards your upwind destination. This is especially true in light winds. With the better speed, you'll cover the longer distance in less time than it will take to cover the shorter distance at slower speeds. The result is getting to your destination sooner.
When operating your business, especially when revenue is tight and other resources are limited, your priority should be cash flow first, then profit. Profit is an accountant's calculation and what you pay taxes on. Cash flow is the life-blood of your business. You need positive cash flow to keep your business moving forward. Once you have positive cash flow, you can work on improving your profit. Let's examine both profit and cash flow in more detail:
Profit is the difference between income and expenses. Profit does not account for asset purchases, the repayment of loan principal or increases in working capital demands. And profit is affected by non-cash items such as depreciation. Depreciation is a way to account for the loss in an asset's value over its economic life. Depreciation expense does not require a current outlay of cash, though it does reduce profit. Profit is a myth-a number on a financial statement-until it is turned into cash. Cash you can use to pay your vendors, your employees and yourself.
Cash flow describes the ebb and flow of cash due to internal operations. Booking a sale and sending an invoice is only part of the process. Your customer has to pay the invoice for the cash to flow in. Your business pays its operating costs for things like inventory, raw materials, subcontracted services, freight, marketing, sales commission, direct and indirect labor costs and taxes with the cash it has received from customers paying their bills or from the cash you have in the bank from loans or investments. You also pay your employees their wages and other benefits with this cash. Cash flow is affected by cash transactions such as investments in brick & mortar facilities, equipment or other fixed assets. Cash flow is also affected by the cash sent to and received from external sources, such as lenders, investors and shareholders, e.g., obtaining a new loan, loan repayment, stock issuance, and dividend payments.
When cash flows out faster than it flows in, your company may run short of cash. In the short term, your business it cash profit does not have to generate profits as long as it has cash reserves to operate with. Companies that are profitable run into difficulties when they run out of cash due to rapid expansion or slow collections from their customers. With inadequate cash reserves, your company can't purchase any more of the products or materials it needs to make sales to your customers. Sales decline and cash receipts decline further.
It its simplest, managing cash flow means delaying outlays for as long as possible, and avoiding any unnecessary outlays, while encouraging those customers who owe money to pay as soon as possible. If your company is generating a profit and expansion is done in a controlled fashion, your company's cash reserves will build up over time. Careful inventory management is also a vital part of cash flow management. Inventory or raw materials sitting on your shelves is cash sitting on your shelves. Strike a balance between having too little inventory, which can mean missing out on sales due to an out-of-stock position, and having too much inventory. Avoid carrying excess inventory that could become unfashionable or outdated. It may be better to take a loss on some old inventory and generate cash flow than to leave the inventory sitting on your shelves.
Companies go out of business not because of a lack of profit, but because of a lack of cash and other valuable resources. If your company runs out of resources, like cash, personnel, raw materials or inventory, you are out of business. This is why understanding and monitoring your cash flow is so important. Business growth and profitability. Most entrepreneurs would consider these to be the Holy Grail of business ownership. So it's not too surprising that many participants in the financial workshops I lead are surprised when I tell them that instant profits and rapid business growth aren't always a cause for celebration.
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