Sin number 4 - Thinking profit equals cash flow
By Greg Carroll
You may find this hard to believe but it is possible for a profitable business to run out of cash, and consequently go out of business.
The primary reason for this is one of timing. A profit and loss statement reflects the income generated by a business less expenses incurred by the business for a fixed accounting period, usually monthly or annually. The profit and loss however, does not reflect the timing of the various ebbs and flows of cash within the accounting period. I will use the example below to illustrate.
EXAMPLE
ABC Consulting Pty Ltd consults to small and medium enterprises. It generates income through fees for consulting work provided to its clients. Because it is a service based business its major overhead is staff.
Below is a summary of the Profit and loss statements for AUG 2004 and SEP 2004
|
|
AUG 2004 |
SEP 2004 |
|
Credit sales |
$40,000 |
$40,000 |
|
Less expenses |
|
|
|
Advertising |
$3,000 |
$3,000 |
|
Cleaning |
$500 |
$500 |
|
Electricity |
$500 |
$500 |
|
Interest |
$5,000 |
$5,000 |
|
Lease payments |
$1,000 |
$1,000 |
|
Motor vehicle expense |
$1,000 |
$1,000 |
|
Rent |
$8,000 |
$8,000 |
|
Superannuation |
$1,350 |
$1,350 |
|
Wages |
15,000 |
15,000 |
|
Total expenses |
$35,350 |
$35,350 |
|
Net profit before tax |
$4,650 |
$4,650 |
Looking at the above example you could easily assume that this business is traveling well with a net profit margin of over 11%.
Let's however now assume the following and track the businesses cash flow though September:
- Credit sales are payable 30 days from the date of invoice, and the business only invoices at the end of the month
- Cash at bank as at 31 August 2004 is $30,000
- Advertising is payable 15 days from the end of the month.
- Staff are paid fortnightly with the next pay day on September 14
- Interest is payable on the last business day of the month
- Rent is payable in advance at the start of the month
- Lease payments are payable on the 10th
- Other expenses are payable during the month in which they appear
So how does this impact on ABC's cash flow
|
DATE |
ITEM |
AMOUNT |
BALANCE |
|
1 Sep |
Opening balance |
|
$30,000 |
|
1 Sep |
Rent |
-$8,000 |
$22,000 |
|
5 Sep |
Motor vehicle exp |
-$500 |
$21,500 |
|
8 Sep |
Cleaning |
-$250 |
$21,250 |
|
10 Sep |
Leasing |
-$1,000 |
$20,250 |
|
14 Sep |
Wages & Super |
-$8,175 |
$12,075 |
|
15 Sep |
Advertising Aug |
-$3,000 |
$9,075 |
|
16 Sep |
Electricity |
-$500 |
$8,575 |
|
20 Sep |
Motor vehicle exp |
-$500 |
$8,075 |
|
24 Sep |
Cleaning |
-$250 |
$7,825 |
|
28 Sep |
Wages & Super |
-$8,175 |
-$350 |
|
30 Sep |
Interest |
-$5,000 |
-$5,350 |
|
30 Sep |
Sales Aug |
$40,000 |
$34,650 |
Referring to the table above you can see that on 28 Sep there is a cash flow short fall of $350 which increases to $5,350 when the interest falls due on 30 Sep. Fortunately sales for August are also banked on 30 Sep and the account is brought back into credit.
Imagine the consequences however if ABC's clients did not pay by the due date. Let's say they didn't pay until 4 Oct. The account would then go further overdrawn as rent of $8,000 is due on the first of the month.
The important message here is to understand that while your business might be profitable, this in itself in not a guarantee of viability. The above example shows that it only takes a minor shift in the timing of payments to have dramatic consequences.
Also remember that a profit and loss records expenses that are deductible for tax purposes. For example the business has an interest expense which is attached to a loan. If that loan was being amortized the principal reductions would not be recorded in the profit and loss, only the interest expense. Therefore it would not reflect the true cash position of the business.
The other big item that gets missed is tax. The introduction of GST means businesses need to be on top of their cash management. A business can be traveling along nicely with plenty of cash in the bank and then suddenly there's tax to pay and it's a scramble to get the money together. Your estimated tax bill should be incorporated into your cash flow forecasts so you know in advance you need to have funds to cover it. You need to treat it like any other expense.
This is why having a cashflow forecast is essential for a business.
Are you on top of your cash flow?
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