Profit is one of the main purposes of being in business, however many small businesses fail because owners do not understand the difference between cash flow and profit!
It is often not fully appreciated by business owners that making a profit, does not necessarily mean cash flow will be positive. It is vital to understand the difference between them and that profitability and good cash flow do not necessarily go together. Fundamentally you can have a profitable business, but don’t have the cash on hand to pay bills. Consequently profitable businesses can go out of business because of cash flow problems.
Any business that fails to forecast its cash flow appropriately is headed for trouble. Without proper and accurate cash flow projections, management is unable to identify future cash requirements and hence lacks vital information about the financial direction of the business. Ideally each business should have a budget showing expected future income and expense levels and the minimum return to the owner. A carefully developed cash budget is considered to be the best tool for determining the proper amount of cash needed to keep the business operating smoothly. It also is vital for each business owner to know the point at which, the business will break-even. This is the point at which the gross profit (revenue less direct costs) equals total fixed costs.
When cash flow is decreasing, business owners have to look closely at how to reduce the stream of regular expenses that threatens to drain the bank account completely. Every business needs to look at ways of increasing cash inflows and delaying cash outflows wherever possible. There are several ways a business might manage its cash flows:
Manage creditors and debtors effectively;
Don’t carry too much stock because it ties up cash in unsold products, and it costs money for storage;
Put money aside to make timely payments for GST and PAYG tax liabilities.
Lease new equipment rather than buying it outright
Renegotiating your contracts with suppliers
If you have addressed the issue of cash flow and still have profitability issues, then you might want to consider reducing your overheads. The thing that all successful businesses seem to have in common is that they manage their costs effectively. They do this by reducing their overheads as much as possible to maximise their potential profit.
Controlling cost overheads is one the greatest cash flow protection strategies for a business. The most successful businesses constantly analyse their overhead costs and look for ways to reduce them. However, many overheads must be maintained at reasonable levels – cutting them out entirely may be disastrous to the business. However, cash flow management alone is not enough, your business must be returning a profit. The long term trend of both must be positive. Hence it is vital to appreciate the importance of the interaction between profitability and cash flow, as these are two areas over which you do have control, if you implement policies to achieve optimum results.
Profit and Cash Flow
It is often not fully appreciated by business people that making a profit do not necessarily mean cash flow will be positive.
A wise man once said, “Profit is an opinion, but cash flow is a fact.”
The following is a list of items that often contribute to there being differences between profit and cash flow.
- Debtors
- Work in progress
- Stock
- Fixed assets
- Shortened supplier terms of credit
- Change in sales mix, with an increasing proportion of credit sales as opposed to cash sales
- Loan repayments
- Taxation
- Dividends
- Depreciation
The cash flow budget and the other scenarios we will prepare on your behalf will take these factors into account. However, please do not hesitate to ask us if you require further clarification in this important area.
Cash Flow
Any business that fails to forecast its cash flow appropriately is headed for trouble. Without proper and accurate cash flow projections, management is unable to identify future cash requirements and hence lacks vital information about the financial direction of the business.
However, “cash flowing” alone is not enough, the business must be returning a profit. The long term trend of both must be positive.
Ideally each business should have a budget showing expected future income and expense levels and the minimum return to the owner.
It is vital for each business manager to know the point at which the business will break-even. This is the point at which the gross profit (revenue less direct costs) equals total fixed costs.
Knowing these revenue levels and monitoring them regularly will equip the owner to know from month to month how his or her business is performing.
Low profit months will generally impact on cash flow in the current and following periods. Therefore the ups and downs in turnover will usually be mirrored in cash flow projections.
Hence it is vital to appreciate the importance of the interaction between profitability and cash flow projections.
There are many signs on the road to failure and if these are addressed then survival is more likely to be assured.
For more information concerning the above please contact The A Firm’s Taxation Executive Julie Sabo on 07 5596 4604