In small businesses, it’s not uncommon to accrue millions of dollars in revenue each year without actually producing any meaningful cash flow. You may very well know how frustrating it can be to show profit on your income statement, but not have money in the bank. One part of this issue is a fundamental misunderstanding of how cash flow and profit differ—and yes, they’re different! The other is that many business owners simply aren’t monitoring how cash is moving through their company. To make choices that enable growth and profitability in your business, you have to take control of your cash flow. Here are two things you need to know to get started.
1. Understand cash flow versus profit
Cash is to your business as fuel is to your car: If you run out, you stop. So your primary business goal should be to keep your cash flow healthy. You can have plenty of profit and still run short on cash. Why? Because in basic terms, profit is revenues and expenses projected, planned for or promised, while cash flow is revenues and expenses realized.
Profits measure the value that flows through your business operation. And the value moving through your business in a month can be very different from the cash that moves through it in that same month. Consider these different scenarios:
- Imagine your business paid $1,000 for office supplies. Because office supplies are an operating expense, this reduces your net profit by $1,000 on your income statement. It also reduces your cash position, because you disbursed money when you paid your supplier. So, you see lower profits and less cash on hand.
- Imagine that your business made a $1,000 principal payment toward a loan. Since this loan doesn’t pay for anything you need to run your business, it doesn’t appear as an operating expense for the month, and your net profit doesn't change. However, your cash position goes down because you disbursed money. In this case, your net profit stays the same but your cash reduces.
- When you took out that loan—say it was $10,000—it didn't appear as revenue because you didn’t sell a product or service to get it. So your net profit doesn’t change, but your cash position increases by $10,000, which strengthens your cash flow.
- When you buy raw materials from a supplier on credit, the purchase is an expense on your income statement. So it immediately reduces your profitability, but doesn’t affect your cash flow until you actually disburse the money.
Based on changing variables, your business can show both profit and negative cash in the same month.
It’s true that you can actually run your business unprofitably for a while, as most startups and seasonal businesses do. But if you continue to be unprofitable, your business will eventually fail. But running out of cash is a different story. The effects of a cash deficit or surplus are immediate. If you run out of cash, your business stops.
2. How to create a cash flow statement
One new EMyth Client recently told me, “I have no clue whether or not I have a cash flow statement, but I for darn sure don't generate any forecast.” Aside from the clear red flag that this business owner is abdicating his finances and has no idea what’s happening financially in his business, he’s not tracking how much cash he actually has in the bank—meaning his company may not be long for life.
A cash flow statement—which differs from your income statement—traces the actual flow of funds into and out of your business during the past several months. It includes:
- Your beginning cash position at the start of the time period.
- Cash receipts or disbursements during the period, which add to or reduce your cash position.
- Your ending cash position as of the end of the period.
You either have a cash surplus or shortfall during the period—that’s your cash flow. The ending cash position at the close of one period is the beginning cash position for the following month.
If you aren’t already creating a cash flow statement, your accounting software should be able to produce cash flow statements for at least the preceding twelve months, which can help get you started. If you (or your accountant) don’t have enough reliable historical information in your accounting software, then you’ll need to pull the information together from other sources. The most basic way to begin is by going through your business bank accounts, and adding up all the receipts and payments for each month in the past.
- Establish categories for receipts and disbursements.
- Group the line items that represent deposits under receipts and line items that represent payments under disbursements.
- For each month, add the receipts and disbursements in each line item category and enter that total per line item into the cash flow statement.
- Subtract total disbursements from total receipts. That gives you your net cash flow—the amount of cash your business gained or spent during the month.
- Record the cash balance at the beginning of the month (beginning cash position), add the total receipts, subtract the total disbursements, and the result is your cash position at the end of the month (ending cash position).
Aim to produce cash flow statements for three, six or twelve of the previous months. This historical view into your cash position will help you create a cash plan and forecast so that you can more strategically leverage cash to increase profit. If you’d like the support of a coach on your path to understanding cash flow in your business, we’re happy to help.