Jane Adams had a retail business with very good sales. Every month, Jane’s accountant presents Jane with her financial statements telling Jane she is doing very well. But every time Jane looks at her bank account it does not reflect what she sees in the profit and loss statement. Every year, Jane has to take a loan to pay her tax bill and she is beginning to wonder, if I really make that much money why don’t I see it?
This problem is one I often hear entrepreneurs complain about. If I am really making that much money, why does my bank account not reflect it? There are many reasons why this may be and this article tries to shed some knowledge on possible causes.
Cash tied up in inventory
Entrepreneurs usually don’t have the knowledge to compute the full cost of holding inventory. Besides, the price paid to obtain the inventory there are other costs involved such as:
-
Opportunity cost
- Investment income
- Investment in other profitable products or ventures
- Cost of storing inventory
- Cost of damaged or spoiled goods: Overtime stored inventory becomes outdated and less likely to sell
- Employee time associated with stored inventory
Just because your vendor offers you discounted goods does not mean you have to stock up. You have to evaluate the offer in light of how it will affect your overall business. You are better off paying a little more later knowing you can sell your inventory than stocking up on inventory customers are not likely to buy.
Building assets with little liquidity
Trying to finance all asset purchases with business cash also contributes to less cash in the business. For example, working capital loans can be used to finance inventory, long term loans can be used for long term assets. The life span of the asset should match the type of loan you take. For example funding short term assets with long term loan could be very costly.
Building sham assets
Business assets should bear relationship to profits. They either help increase revenue or help reduce expenses. Buying more assets than you need is costly and adversely affects your cash flow. For example, a business might need a vehicle for business purposes, but does a small business owner really need a luxury car? There are stages of growth and they will come a time you can afford luxury but taking the plunge before you are financially ready could bankrupt you.
Not knowing the difference between good and bad debt
Good debt is debt that earns a return above the interest rate required on the debt. In order for a business debt to qualify as good debt, the business should be able to make more money after acquiring the debt. On the other hand bad debt either creates no income or creates income less than the interest rate paid on the debt.
Bad debt inhibits growth and drains cash flow. I have met business owners with problems on both side of the equation, that is pile on bad debt versus shunning all forms of debt. Both side of the equation are very limited in their vision. Good debt gives you the leverage you need to grow.
Cash used to pay loans
Cash used to pay loans does not appear on the profit and loss statement so a business owner who depends on profits to measure cash flow is very limited. When loan payments are applied, interest expense shows up on the Profit and Loss statement (P&L) while the principal is applied to the loan. The loan payment will not be reflected in the P&L but will reduce the outstanding liability on the balance sheet. Due to such differences between the profit and loss statement and cash flow, the net income or net loss will not be a direct reflection of the change in cash for a particular period of time.
Accounts receivable
When you sell a product or provide or service, it shows up in your profit and loss statement as revenue in your accrual basis profit and loss statement. However, not all amounts you count as revenue has been received as cash. Not collecting from customers on a timely basis adversely affects your cash flow.
Prepaying too many expenses
Paying your expenses even before they are due could be another source of cash flow blockage. If you are short on cash, hold off on prepaying expenses and take time to plan your cash outflow.
Unprofitable customers/ products
Not knowing the contribution margin of each product line could be very costly to your business. If you have five product lines, and one is not profitable, you could be losing money without knowing it. If the product lines are not tracked separately, the loss is masked with the profitability of the 4 other product lines.
This also applies to not knowing the cost of serving your customers. You could be losing money on certain customers but because you make profits as a whole, you are not aware of the cash leak. Moreover, small business owners fail to see the value of their time as a true cost incurred in their business.
In summary, profit and cash flow are not the same thing. Bad accounting, poor cash management, etc. can hamper your cash flow even though your profit and loss statement shows a profit. Unfortunately, you have to pay taxes on your net income irrespective of how much cash you have in the bank. The earlier you gain control of your cash flow management, the better for your business.
To increase your financial intelligence, attend our next event.