Cash is king. You’ve heard it forever, but do you know what it really means?
Cash in this context isn’t bills or coins, it’s money in the bank that you can spend today. It’s the single most important resource in any business, and also one that is way too frequently misunderstood.
You need cash in the bank
The problem with cash in business is that we tend to take it for granted. We think in profits, but we spend cash. The issue is, profits and cash are different.
Profits is an accounting concept that depends on a lot of imposed timing constraints for sales, costs, and expenses. Cash, on the other hand, is what it takes to pay your bills.
Although cash is critical, people think in profits instead of cash. We all do. When you imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be. We are trained to think of business as sales minus costs and expenses, which is profits.
However, we don’t spend the profits in a business. We spend cash. Profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health.
Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash as well as profits.
Profits don’t guarantee cash
To some extent, cash flow depends on normal business practices for the industry you’re in.
Product businesses, for example, have to deal with the cash impact of inventory, while service-based businesses generally don’t.
Businesses that sell to other businesses are likely to have to wait for their clients to pay invoices; seasonal businesses have to deal with predictable cycles.
Your cash flow depends on the practices of your specific industry or sector—not how profitable you are.
Waiting to get paid
A business delivers the goods or services to a business customer or client along with an invoice. The check comes later. That’s extremely common in business-to-business sales, and what it means is that the amount of that invoice is included in the month’s sales, and is booked as sales—but it isn’t actually cash in the bank.
Instead, that amount sits in a bookkeeping category called Accounts Receivable until the EFT arrives and it reflects in the bank.
The average time between delivering the invoice and receiving the money is called collection days, or collection period. The problem businesses face is that all the money in accounts receivable shows up in profits as sales, but is not in your bank account. You can’t spend it.
Profitable businesses can go under simply because they have too much money in Accounts Receivable, and not enough in the bank. The money showed up in sales but never made it to the bank. Ultimately, being profitable didn’t prevent business failure.
Buying things before you sell them
Most product businesses, such as stores, have to buy the things they sell ahead of time before they sell them. Manufacturers and assemblers have to buy components and materials before they create and sell finished goods, and that creates a lot of potential cash flow problems.
It’s called inventory: products for resale, materials for manufacturing, components for assembly. Money spent on inventory doesn’t show up in profits until the ultimate sale—but it’s gone, out of the bank, when it’s spent.
For businesses that depend on inventory, inventory management can be critical for cash flow. It’s too easy to have money tied up in inventory that sits on the shelves too long, or never gets sold. That money is gone from the bank account but doesn’t show up in the profit and loss.
Paying your bills later
The opposite of Accounts Receivable is called Accounts Payable, which is money a business owes to its vendors.
Taking 30 or more days to pay invoices is good for cash flow. Every dollar you have sitting in Accounts Payable is money that’s still in your bank, but not in your profits. You subtract expenses from profits when you incur them, not when you pay them.
The real bottom line: Mind the cash flow
The phrase “the bottom line” is a reference to profits, which are the bottom line of the profit and loss statement. But it’s actually come to mean something like a conclusion, or the most important result. That’s why the real bottom line for business owners is cash flow, not profits.
Profitable companies can run out of money due to lack of cash flow. There’s no way around it: To run a business, you have to mind cash flow, not just profits.
If you care about maximizing profits then check out how to immediately increase your productivity