Columnists, Thom Finn, V3I1

The Top 2 Business Killers

In the final analysis, the commercial success of your business comes down to profitability. There are other factors to your success in business. One of my determining factors is engagement and enjoyment. However, when we talk about the commercial success, the only measurement is the profitability.

If you have made it past year one in business, you have mastered the lesson of profitability. But have you thought about cash flow?

In my years of listening, watching and counseling businesses, the top two killers of business are cash flow and profitability, in that order. More businesses quietly close their doors each year across the United States because they have run out of cash, not because their business model will not generate a profit.

Most business owners pay too much attention to profitability. I like to think of profitability and cash flow as two children. These two children are very different.

Profitability is very smart, very logical, and thinks long-term: the next year, two years, five years. Cash flow, however, is needier, and when he gets sick, he has a good chance of dying. So, if you ignore him, and he starts crying, and you still ignore him, when you do finally pay attention to him it is going to take much work to get back to health, if you are not already too late.

Cash flow sometimes does not think as logically, or as long-term, as profitability does, because he only cares about today, tomorrow, next week, and maybe next month.
Enough about the problem, let’s discuss the solution. So, what’s a builder to do?

Run your decisions by both children. Every time you have a financial decision, ask profitability what he would do, and ask cash flow what he would do. Their answers could be surprisingly different.

Moreover, if you are in a cash flow crunch, you should at least listen to cash flow more, if not make your whole decision based on his cries.

Someone once made the statement that “profitability is what you pay taxes on, cash is what you take home.” I wish I had said that because it is a brilliant way to point out the differences. Moreover, in a small business, especially during its formative years (one month to seven years), cash flow performance is critical.

As a small business owner, you must manage and oversee everything that goes on within your business, including employees, production schedules, inventory, marketing, and office supplies. However, unless your business has an ample cash stream, you will not have anything to manage or oversee. Employees need their paycheck, inventory needs to be purchased, your accounts receivable needs to be funded, and supplies need to be replenished—all with cash.

This lesson will explain why cash flow is, in fact, the lifeblood of your small business. The lesson is also intended to provide you with the knowledge and tools necessary to manage your cash.

Say you need toilet paper. The profitability child would say, “Go to the wholesale club and buy 71 rolls of toilet paper because they are only 34 cents per roll and way cheaper than the grocery store.”

However, your Cash Flow child would whine, “No! I know the grocery store price is 89 cents per roll, but you only need three rolls, or $2.67 total we have to spend. Those 71 rolls at the wholesale club are going to cost $24.14. Please, only spend $2.67 and not wipe out what little cash we have.”

That’s the basic lesson. However, if you want to learn more, keep reading.

Step 1. Understanding Cash Flow

Let’s begin with a definition: “Cash flow is the ebb and flow of cash in your business.” Alternatively, here is another one: “Cash flow is the flow of money (cash, checks, electronic debits, and credits) in and out of your business.”

Cash flow is an overview of your checkbook, savings account, and investment account. However, knowledge of those accounts will not:

1. Tell you where your cash is heading.

2. Help you to arrive at any meaningful decisions.

Remember the quote in the introduction of this topic, the one about cash being “what you take home”? In the interest of emphasizing how important cash is (as opposed to profitability), let’s put that statement another way: “If you do not have any profitability, you will not have to pay your taxes. If you do not have any cash, you cannot pay your bills.”

“Profitability” is an accounting term of special interest to people who collect your taxes, while “cash” is the money that resides in your cash register and your checking, savings, and investment accounts. Successfully measuring and forecasting the cash flow allows the small business owner to make myriad important decisions, such as:

• Do I buy a new computer or software system?

• Do I purchase or lease that vehicle?

• Do I hire that new salesperson?

• Do I bring in extra inventory?

• Can I afford to give my special customer an extra 30 days to pay his bill?

Step 2. The Components that Impact Cash Flow

Four primary components are responsible for the ebb and flow of a small business’s Cash Flow. Those components are:

• Profitability
• Inventory
• Accounts Receivable
• FF&E (furniture, fixtures and equipment)

Let’s consider each of them as they relate to cash.

Profitability: Profitability is the number that comes from the bottom line of your Profit and Loss Statement (P & L). It is the figure your accountant transfers to your tax return. In essence, if the bottom line of your P & L is positive, if you have made money, then that profitability positively impacts cash. Make money, your cash increases. Lose money, your cash disappears.

However, the P & L does not tell the entire story, where cash is concerned. There are two reasons for this:

1. There are line items on the P & L
that affect profitability but don’t impact cash—depreciation and amortization.

2. There are line items on the balance sheet that do impact cash yet aren’t part of the P & L. See the explanations below for Inventory, Accounts Receivable, and FF&E.

What this means is that while profitability has a major impact on cash flow, it is not the only contributor. Here are some others:

Inventory: The purchase of inventory requires an outlay of cash, but that outlay does not appear on the P & L. This is because inventory is an asset, similar to cash, accounts receivable, and FF&E, and only appears on your balance sheet.

A build-up of inventory requires an expenditure of cash. If your inventory has increased in the past month, or whatever your financial statement cycle is, then your cash has decreased by a like amount. The opposite is also true:
If your inventory decreases your cash will increase.

Accounts Receivable: Accounts Receivable (AR) is cash you have loaned to your customers between the time they receive your products or services and the time they pay their bills. It takes cash to fund those receivables, which means that if the number of your receivables has increased from one financial statement cycle to the next, your cash has decreased by a like amount.

Furniture, Fixtures, and Equipment: Cash spent on FF&E amounts to expenditures for capital goods. Because capital goods have an extended life (as opposed to supplies, for instance, which are consumed within a year) they cannot be 100 percent expensed on your P & L.

The amount that can be expensed is called “depreciation,” and that amount is determined by various taxing agency regulations.

This means that if you were to purchase a capital item for $20,000 on the first day of your accounting cycle, this would have a negative effect on your cash of $20,000. However, it would only have a $5,000 negative effect on your profitability, assuming that it can be depreciated over four years. This $5,000 shows up as “depreciation expense” on your P & L, while $20,000 is deducted from your checkbook. This is a classic example of the difference between profitability and cash flow.

The single best tool I recommend is to forecast your cash flow. Not a QuickBooks budget, but an actual prediction of what will flow in and what will flow out. It is one of my first recommendations to a new client who answers yes when I ask him in the free session, “Do you ever experience cash flow pain? And if so, when?” This cash flow forecast is tedious, but you will know, sometimes months in advance, when the cash will run out. I would much rather have seven months of notice about cash running out then two days.

Moreover, once we know when the cash dries up, we can make revised decisions such as when to make the large purchase or notify debtors of needed grace. I have this in an email able form for any brave souls that have read this far and would like a copy.


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