We’ve all heard the terms “Cash is King” or “Cash is tight.” But when it comes to business, cash is incredibly important because you have vendors and employees to pay. Maybe you even have loans or credit cards with lingering balances or a car payment and your own take-home salary. All businesses need to have a strong cash position. But what if you have cash but you aren’t running the business at a profit? Or worst yet, what if you don’t have cash but you are showing strong profits? How does this happen and how can you get a full understanding of your financial picture or future?
Let’s explore the first scenario, your income statement is showing a loss at the end of the year but your cash flow outlook is strong. What might be some reasons for this?
You borrowed money from a bank or family member this year or maybe you infused some of your own personal funds into the business (this is not captured on your income statement but it is an inflow of cash).
Maybe you have been slow to pay your vendors – you have cash but you also owe a lot of people a lot of money – take a look at your accounts payable aging report, what’s there? What’s late?
You have high credit card balances (you’re highly leveraged) – credit cards are essentially loans, you are incurring expenses (on your income statement) that you haven’t yet paid for (cash outflow)
What does this say about your business? Profits are necessary for LONG TERM SUCCESS. Cash is necessary for SHORT TERM COMMITMENTS. A company that cannot turn a profit after 5 – 7 years may not be attractive to investors or buyers. So while yes, “Cash is King” but it is not a measure of success.
The second scenario is one that we see more frequently than the first. The income statement is showing strong profit margins and the cash in the bank is low. Why is this happening?
You are using cash in a way that does not affect the expenses on the income statement.
You’re paying off debts, loans, other lines of credits, etc. These amounts show up as liabilities on your balance sheet. The interest related to these liabilities is expensed on your income statement but not the decrease in principal.
You are purchasing assets. Maybe you are purchasing inventory, property, or paying a security deposit on a lease. These items may not be expensed or they may need to depreciate in part at the end of the year as an expense on your P&L. The depreciation expense amounts will not be equal to the cash paid for the asset. It will be less, in most cases, significantly less.
Owner’s Draw – maybe you are a partnership, single member LLC, or sole proprietor. While the money you pay to your employees is expensed and deductible on your income statement, the money you are drawing from the company as the owner (not as an employee) actually is a decrease in equity (balance sheet item) and will decrease your cash but not your profits.
In this scenario, it’s important to plan for tax liabilities and set those funds aside in an account outside of your operating account. And then forget about them. When tax time comes along you have the cash to pay and you’re not tempted to use the cash because you know why you’ve saved it.
The other thing that we see with our clients (but we do not recommend) is paying for non-deductible or personal expenses through the business. These items will be classified as an owner’s draw and as a result, can affect your cash balances but not your profit.
Accrual basis financial information is another scenario we should explore here. Most small businesses use cash basis reporting while it makes sense for some to use accrual basis. This method of accounting in the income statement is based on recording revenues when earned and expenses when incurred…not when cash is received or paid. Cash balances can be affected by all items above but also can fluctuate significantly if customers are slow to pay or if vendor payments are untimely.
So what is the answer to our question, “What is more important, Cash Flow or Profit?” The answer is clear…it’s both. You can’t survive in the long-run without both. Long term success is the goal and short term commitments are an essential part of your operations.
Need help deciphering your financials? Need help cleaning them up? Contact us today!