Why You Should Watch the Cash Flow despite the Profit
You have been busy lately with lots of projects coming in and the accountant gives you the good news that your small business is making a profit. You probably feel like celebrating, loosen up a little, and stop worrying about bank account balance, expenses, cashing in. As sad as it is to spoil the joy, you need to know that this is exactly when you shouldn’t ignore cash flow.
Why doesn’t profit mean the business is doing great?
To put it in short, profit doesn’t reflect current reality. It is a real indicator but is more about theory than practice.
Profit is the positive difference between revenue and the expenses, taxes, and costs brought by the company’s activity. Normally, it is similar to how cash flow is calculated. What differs is the moment to which these two relate. Cash flow, by definition, implies movement, development in a given timeframe; it is a mirror of what happens to the company’s cash at any point in time. Profit, on the other hand, it is calculated per month, quarter or year, at the end of the chosen interval. This means the profit reflects the company’s situation at a fixed moment. It is also calculated based on the financial documents issued or received in that specific time frame, no matter if you actually cashed in an invoice.
To be more specific, having a profit does not mean you actually have that money in your bank account.
How is that possible?
The main reason is payment terms. Working on projects implies that you don’t usually get paid at delivery. You may charge some 30 % in advance, but the payment terms are generally 30 or 60 days after issuing the invoice. Once you did that, however, the document is registered in the accounting software. Thus, although you don’t get the actual money before, say, 60 days, the Accounting will show an increase of income resulting in a possible profit. That surplus of money is real, just not into your bank account yet.
Where is the danger?
As we mentioned before, the great danger of not managing the cash flow is running out of cash. Which, for a small business (or any size for that matter), can mean bankruptcy. If, while waiting for cashing in an invoice, with a nice profit on paper, your bank account is empty, you are not able to pay salaries, suppliers, and really function.
Let’s imagine that…
You have to deliver an important project tomorrow. You are already running late, but if your team works hard enough, you can make it. The Internet provider has issued a bill a month ago, but you just didn’t have the cash to pay it; you preferred to pay the salaries instead. So the Internet provider disconnects you. What happens next? You are not able to finish and deliver the project in due time, which causes penalties. It also delays the work on other projects that may cause, in turn, delays in getting paid, which, in turn, causes an even greater Cash Flow Gap. And the story can go on.
Sounds a little extreme? Maybe; but situations like this have the bad habit of actually happening. And you only need one to put you off the track.
Another reason for which the profit amount on paper cannot be found in your bank account is that unexpected expenses may occur in between accounting periods before the profit is calculated. These outflows drain cash and may leave you with a large Cash Flow Gap and the impossibility to support operations.
So you see, making a profit does not imply that there is enough money available for the daily activity. We know, it’s uncomfortable to think about rainy days, but having an umbrella with you can make an enormous difference for the business (not to mention your nerves).
Enjoy having a profit, but don’t turn your back on cash flow.