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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?

Are you currently in business or planning to start a business in the near future?  Do you have cash flow concerns or want to find ways to improve your cashflow? Are there things you should or could be doing to improve your cash flow now?

 

To find out simply complete our Cashflow Review Form or complete the form below for an initial interview.

This course is not a substitute for independent professional advice. We do not warrant the accuracy, completeness or adequacy of the information or material in this course. All information is subject to change without notice. We and each party providing material displayed in this course disclaim liability to all persons or organizations in relation to any action(s) taken on the basis of currency or accuracy of the information or material, or any loss or damage suffered in connection with that information or material.