Have you been wondering why your business feels like it’s making healthy profits, but it feels like you never have any cash in the bank? Then this article is for you. We’ll be covering the difference between cashflow and profit as well as some tips on how to improve your cashflow.
Before we get into the difference of these two concepts, we’ll cover some financial reporting basics. At the end of your financial period, your accountant will generally provide you with a balance sheet, income statement and statement of retained earnings and, sometimes, a statement of cashflows.
The Balance Sheet
The balance sheet deals with the assets that you own and debts that you owe. Example of assets include your bank account, equipment, items that you have prepaid as well as sales amounts that you are expecting to receive but haven’t received yet (otherwise known as accounts receivable). Examples of debts that you owe like credit card bills, bank loans and money that you’ve received from clients for service you still have yet to provide and other bills you have outstanding (a.k.a. deposits and accounts payable).
The Income Statement
The income statement looks at the amount of sales that you have earned during the year less the expenses that you have incurred to earn that income. Depending on the type of business you have, let’s look at retail for example, you may have had to purchase inventory to make that sale and that cost is subtracted from your sales to calculate gross margin.
There are some other deductions, such as amortization/depreciation on equipment purchases, that are non-cash expenses that are deducted on the income statement. The rules covering this are beyond the scope of this article however it is important to note that all expenses listed on your income statement are not necessarily cash amounts that were paid during the year.
At the end of this statement, your profit or loss for the year will be determined showing the starting point for your tax return for that year.
Statement of Cashflows
The statement of cashflows is divided into three sections, operating, investing and financing and will look at the amounts of cash you had at the beginning and end of your fiscal year and show you how much was spent in each area.
Operating refers to cash received/spent in the sales and expense categories of a business. Investing looks at what equipment or portfolio investments were purchased and sold. Lastly, financing looks at the amount of loans that were extended or repaid during the year.
Non-cash expenses like amortization/depreciation, also get added back since they didn’t affect the company’s cash position during the year.
Most small business don’t require a statement of cashflows as most of their activities fall under the operating area and investing activities occur are fewer and farther in between.
Given the concepts above, profit is a mix of the company’s financial results that include primarily cash and some non-cash items over a period of time. Cashflow on the other hand looks primarily at how much cash you have now and take into account that cash can cover your upcoming bills or, will you be receiving cash to cover those bills? The amount of bills that you have to pay will be listed on the balance sheet as well as the amount of cash that you expect to come in.
The Importance of Cashflow
Cashflow can make or break businesses, that’s way it’s important to ensure that you are aware of how much cash you have in the bank now and to make sure that you can cover the bills. Cashflow is also all about timing since sometimes you may have a client who will pay you $30,000 for an invoice in two months time, but you have $30,000 in debt that is due today and no other cash on hand. With the right amount of planning some of those bills could have been for gone and purchased later or the due date for your invoice could have been moved up through your terms.
The terms of sale that you list on your invoice is an important aspect that is often overlooked. What we mean by terms are the number of days that you give clients to pay their invoices. There are no standard terms that have to be followed, you as a business owner have the freedom to set your own terms.
Terms that are commonly used include, “Due on receipt” and “2/10, net 30”. Due on receipt means that payment is due on the same day that the invoice is issued. The term 2/10, net 30 has a lot packed into so few characters. First, let’s dissect “2/10”. It looks like a fraction but for accounting, this means that you’ll be offering a discount of 2% if your customer pays their invoice in 10 days. The “net 30” portion means that the customer has 30 days to pay their invoice if they are not taking the discount. Different variation of this can be “3/5, net 60” meaning a 3% discount if paid in 5 days, otherwise the invoice is due in 60 days or just “net 15” stating that there are no discounts being offered and the invoice is due in 15 days.
A Note on Profitability
Sometimes there’s a disconnect when businesses are bringing in a lot in sales but your income statement is saying otherwise. When this happens make sure that you have a good sense of your costs. First, we would suggest looking at your expenses and making sure that they are all required to run your business or if there are some extras or nice-to-haves tucked away in there. Once you’ve done that, look at your gross margin to see if that can first cover your expenses and, in an ideal world, that would also include your expected profit. Then if that is still not working out the way you expected, it’ll be important to look at the selling price of your product or the price of the goods you are selling. Lastly, you can also look for grants that the government may offer, such as subsidies for hiring summer students or credits for hiring red seal apprentices.
Our first example is a company that brings in $15,000 a month however, their operating costs are $18,000 a month showing that even though there are notable sales coming in the door, they can’t cover their everyday costs. Looking at expenses would be a good way to start. Sneakily tucked away in the expenses are redundant monthly software costs of $500 and additional phone lines that you’re no longer using amongst your other expenses.
Our second example is a seasonal business this is run out of their home primarily in winter and summer and had to shut down from mid-March to mid-May. They also usually only add one or two more staff members each busy season. In the age of COVID-19, these would generally be their slowest months however in 2020, they were closed. Your first thought would be that this year would have less profit than their 2019 year, however, while they were closed, they only had to pay very few of their daily operating costs. So, even though their overall sales for the year have decreased, their profit was higher because they didn’t have to pay overhead costs for months that didn’t generate a lot of sales.
Take Home Point
While both profitability and cashflow are important, make sure that you are watching the amount of cash that you have in the bank to make sure that you can cover your bills as they come due and that your company can make it through the hard times.