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Financial Analysis - The Difference Between Profit and Cash

January 8, 2018

 

 


I’ve never met a business owner that went into private enterprise with a view of failing. The vast majority of business owners are highly capable with a vision of succeeding and contributing to society through their commercial endeavours.


Unfortunately, as we know, not every business makes it.


Many business owners will diligently print their end of month Profit and Loss Statement and Balance Sheet, then scratch their head wondering why they are making profit but have little cash in their bank. Indeed, there are countless examples of good businesses going broke while making money.


Why is that? So often the answer lies in the third (and some would say most important) financial report - The Cash Flow Statement.


The Cash Flow Statement is the link between the Profit and Loss Statement and the Balance Sheet. Essentially it tells the business owner what cash came in and what cash went out. Often, so much of that delicious profit from the Profit and Loss Statement gets stuck in the Balance Sheet without being released into the company bank account.


When the company has no cash in its bank the business owner will often reach out to third parties to improve the cash position. They may contribute more of their personal funds to the company by way of loans, they may apply for bank debt or they may fail to pay their statutory debts such as the Business Activity Statement (BAS). 


All of these options are fraught with cost and risk. In so many ways the Australian Taxation Office (ATO) has become the largest working capital funder in Australia as the ATO does not have the opportunity to decide if it wants to extend the credit. The ATO only become aware of the existence of the debt once certain lodgements are made by the business owner.  However, this approach so often ends in disaster with the ATO pursuing the company into liquidation to recover its debt.


How could that outcome be avoided? Back to the difference between profit and cash. There exist three swing factors that impact the cash at bank position of a business:

 

1. Accounts Receivable 

This swing factor comes down to the credit terms given to clients and how well these credit terms are managed. So often there is cash sitting in a client’s bank account that could be in the company bank account.


Having an effective Accounts Receivable function is so often the difference between a healthy cash balance and the inability to pay debts when they fall due.

 

2.  Inventory Management

Full shelves and diverse product lines might look and feel enticing but the whole purpose of acquiring the inventory is to convert it to cash from customers as soon as possible – not to have it sitting on shelves or in storage. By the same token, the business owner does not want to lose sales because they had insufficient inventory.


Inventory Management is undoubtedly a balancing act and there are ratios to measure the effectiveness of inventory management.

 

3. Accounts Payable

The third swing factor relates to the credit terms a business receives from its suppliers. Being the flip side of Accounts Receivable it is the cash that is in the company’s bank account and not in the suppliers bank account. In simple terms it is the supplier funding the business.


Failure to pay creditors as and when they fall due is warning sign of insolvency so those generous credit terms that allow cash to remain in the bank account of the business need to be adhered to. When cash flow gets tight it really comes down to communication. Often suppliers will be flexible and agree to payment plans when the business owner is transparent but if commitments are broken the business may be at risk of interest charges, stopped supply or in the worst case, insolvency.


Among the myriad of issues, a business owner must be across to succeed undoubtedly cash flow management is key. By understanding the difference between profit and cash the funding requirements of a business can be calculated and planned for.


My top five tips for business owners to stay on top of their cash flow management are:

  1. Meet regularly with an accountant or business advisor to analyse and understand financial ratios;

  2. Establish and enforce a good accounts receivable/credit management policy;

  3. Streamline inventory management; 

  4. Understand supplier credit terms;

  5. Establish funding lines in advance to bridge the gap when cash flow issues arise.

 

 

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