 Do profitable companies fail? Yes.Do companies with high cash flow fail? Yes. So, companies that are profitable with high cash flow fail? Obviously Not!
CASH FLOW
Cash constantly moves in and out of a business:
In from: customers, investments, and capital from the business owner/s Out to: suppliers, staff, government (tax, NI, VAT), interest (bank borrowing, loans), share holders
If you trust your cash flow to luck, you are more than likely to suffer cash flow problems. You must be aware of:
- What cash will flow in, and what cash will flow out
- The amount of cash
- And most importantly, when the cash will flow in or out
There are two types of cash flow documents that need comprising on a monthly basis. The first document is the 'Cash Flow Forecast'. The forecast is your estimate of your cash income and expenditure over a period of time. The second type of cash flow document is a 'Cash Flow Statement'. The statement records your actual cash income and expenditure at the end of the 'forecasted' period. The closer the 'Forecasted' figures match the actual figures (Statement), in financial terms, the more understanding and control you have over your business: as what you estimate will happen, usually does. When you have the ability to get the figures close you will be able to:
Judge how much cash your business needs to be solvent
Determine future sales figures
Determine your own drawings and benefits And plan in advance the amount of capital and/or borrowing the business needs for various reasons (growth, new markets, more staff/stock) To understand why high cash flow and good profit can be a reason for failure we need to understand the relationship between cash and profit.
PROFIT Gross profit: | this figure is the total amount of profit on all sales after deducting the direct cost of making the goods or supplying the service. Leather is a direct cost of a shoe, as is the shoe maker's wages: the shoe salesman's car and wages are not. | Net profit: | is the figure (positive or negative) that remains after all of the business income and expenditure is finalized. |
Profit, unlike cash, lacks visibility (to the untrained eye) and is therefore the catalyst for many a company's downfall. In a simple example: If you started a new business and bought 100 music CD's at £2 each, a total of £200 (all your savings), and then sold all of those CD's at £5 each: WEEK 1 what would be the the profit ? Sales 100 x £5
| £500
| Cost of Sales 100 x £2
| £200
| Gross Profit
| £300
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what is the change in cash flow ? What you can see above is in an uncomplicated business the figures are simple and allow effective planning. Now suppose we look at the above scenario at the end of the following week. WEEK 2 what would be the the profit ? Sales 100 x £5
| £500
| Cost of Sales 100 x £2
| £200
| Gross Profit | £300 |
what is the change in cash flow ? Opening Cash
| £500
| Payments 100 x £2
| £200
| Balance of Cash | £300 | | | | Receipts 100 x £5
| £500
| Closing Cash
| £800
| Cash Improvement | £300 |
The above scenario is still uncomplicated. We have a cash balance of £800 made up by 2 x £300 profit and our original stake of £200. Now we will take some credit from the CD supply shop. WEEK 3 what would be the the profit ? Sales 100 x £5
| £500
| Cost of Sales 100 x £2
| £200
| Gross Profit | £300 |
what is the change in cash flow ? Opening Cash
| £800
| Payments (30 Days Credit)
| £0
| Balance of Cash
| £800 | | | | Receipts 100 x £5
| £500
| Closing Cash
| £1300
| Cash Improvement | £500 |
We now have cash of £1300 made up of 3 x £300 profit (£900), our original stake of £200, and a creditor for £200. At this stage the business has a healthy cash flow and profitability. As with most businesses, our CD seller cannot just buy more CD's to make more profit as the market cannot handle it, or as a new business you have to build the custom. However, you do need more choice to get customers to return: so the next week a shop is rented and more stock purchased on credit. WEEK 4 what would be the the profit ? Sales 100 x £5
| £500
| Cost of Sales 100 x £2
| £200
| Gross Profit | £300 |
what is the change in cash flow ? Opening Cash
| £1300
| Payments
CD's (last months credit)
| £200
| Rent Deposit
| £200
| Balance of Cash | £900 | | | | Receipts 100 x £5
| £500
| Closing Cash
| £1400
| Cash Increase | £100 |
| | Stock at cost £500 | |
The £1400 is made up of £700 profit, £200 original investment and £500 to the creditor that supplied this weeks CD's. You can start to see the gap between profit and cash: you have a healthy cash flow (£1400), but only half of this is profit. The more the business builds (staff, stock, premises, tax's and of course, sales) the more intricate the calculation of cash to profit becomes. Of course you now have stock worth £500: but when you need cash, stock becomes worthless. Relevant Articles The Cash Flow Forecast
The Cash Flow Statement
The Balance Sheet
The Profit & Loss Account
Budgeting
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