Profit does not equal cash flow
Your business can fail even though you are making good profits.
How can this be possible?
One main reason is cash flow. Many business owners do not focus on generating consistent cash flow. Even if they are selling good amounts of products or services, unless that money is coming into the business when it is needed, they will not be generating the cash flow they need to keep to keep the business running.
As we all know, lack of cash is one of the main reasons why businesses fail. So there is no need for me to talk to you about the importance of cash for business survival. But before we talk about how to calculate or improve your cash flow, let’s talk about the basics.
What is cash flow?
Cash flow is the movement – the flow – of money into and out of your business.
- Cash flow in: this is money that is coming in from customers who are buying your products or services. If you sell on credit, some of your cash flow will also be coming in from accounts receivable, meaning cash from customers who pay at a later date.
- Cash flow out: this is money that is leaving your business. This can be rent, loan payments, payments to suppliers, salaries and other expenses.
Good cash flow and bad cash flow
When you observe your business, what kind of cash flow do you see?
- It takes a long time for you to receive cash from your customers. This causes cash crises in the business and you are forced to find money elsewhere to keep running the business. For example: many of you sell on credit and then you find your customers dragging their feet to pay. This is bad cash flow.
- Cash comes in immediately – or soon after – you have sold the product or service. This means that your business has cash available to handle expenses and keep the business operating. This is good cash flow.
Your small business cash flow situation
The other thing to look at is your cash flow situation.
- If more money is flowing into your business than the amount that is flowing out, your business is in a “positive cash flow” situation. It means that you have enough money to pay your expenses. This is a good situation to be in.
- If more money is flowing out of your business than what is coming in, your business is in a “negative cash flow” situation. This is not a good situation to be in because it means that you may not be able to pay all your expenses on time. This situation may even force you to look for money elsewhere so that you can keep running the business.
Who should pay attention to cash flow?
All businesses should pay attention to their cash flow but particularly small and medium-sized businesses. Why? These businesses usually do not have financial reservices or only low financial reserves. This means that their reserves may not be enough to carry them through the period of negative cash flow.
These businesses may also not be able to access other sources of funding, like loans or crowdfunding. And if you do not have money to run the business, your business cannot survive.
Note: profit does not equal cash flow.
It is possible for a business to be profitable and still have negative cash flow. It is also possible for a business to be making a loss while having a positive cash flow.
For example: you are a manufacturing company. Due to COVID-19, customer demand has dropped. As a result, your business is making a loss. Let us say that you have been making a loss of € 2 000 per month for the past 6 months.
After observing the market, your conclusion is that market demand will start to improve 3 months from now, but it will not return to the pre-COVID-10 level. Meaning there is no need to produce the same amounts you used to produce. So you decide to sell some of your production equipment for €1 000.
The buyer pays in cash. That is cash flowing into the business, giving you a positive cash flow. But even though money came in, your business is still operating at a loss.
Business owners often focus on doing marketing, to attract new customers. This is good. But if you do not understand your financial situation and plan ahead, your business will struggle and may even fail.
One of the main reasons why a business has negative cash flow is because customers do not pay on time. If you go online and do research into why small businesses fail, you will see that a negative cash flow situation is the number 1 cause.
This means that business owners should be paying close attention to their cash flow. At all times, every business owner should know:
- How much cash is coming in and when?
- How much cash is going out and when?
There are also some businesses that should always pay additional attention to their cash flow.
Businesses that are just starting or planning to start.
When you are starting a business, you need money to buy goods and pay for certain business expenses. Most of the time, you will be paying for these things without any money coming in from customers.
Many business owners who are starting realise this, so they borrow money from friends, family, banks or other funding sources to cover the first 1 or 2 months of expenses. And they look to the business to start bringing in money from month 2 or 3 so that they can use that money to keep running the business.
However, many of them fail to take into consideration that sales may be less than what you expected. It may take a longer time for customers to get to know you or to buy the amounts that you expected them to buy.
While running your business, you may also find that your price is too high and customers go elsewhere. Or your price is too low and your profit is not enough to cover your expenses. Or even that there are expenses that you did not expect. As a result, your business starts struggling financially.
Every business that is planning to start should take the time to do a good cost estimate as well as a good sales estimate. You need to understand what you are dealing with. And unless you already have customers lining up to do pre-payments for what you are selling, you need to have enough money to carry you through for at least 6 – 9 months before you start the business. If possible, try to find ways to generate additional money so that you can build financial reserves.
Cash flow for seasonal businesses
As a seasonal business, you have more money coming in during certain times of the year and less money coming in at other times of the year. You need to manage your income and expenses so that you can save money to take you through. But you also need to manage your cash flow so that the money coming in and the money going out are in balance.
Any business that has delayed payments
For example: if you are a manufacturing company, maybe producing furniture, you need to buy materials and equipment to start producing but you cannot sell until your product is finished. At the same time, unless you are producing for a specific customer, it may take some time before a customer comes to buy your product. This is also the case if you are a retail business selling groceries, clothes or even office supplies.
If you want to know if your business has good financial health, you need to have a good understanding of your cash flow. If you want to know if your business will be able to survive in the long term, you need to have a good understanding of your cash flow. Understanding your cash flow will help you plan for the future. You will know when your business will have financial shortfalls and this will allow you to take action instead of waiting for the crisis to hit you. In short, if you want your business to be successful, you need to have a good understanding of your cash flow.
Check back on the blog next week to learn how to calculate your cash flow. Or sign up for my email list and you receive a weekly email telling you whenever I update my blog with advice.