Its common sense to think that if you made a net income that you would have a positive cash flow as well. Unfortunately, that’s not always the case in business. You have accounts payable, accounts receivable, depreciation, WIP accounts and so on.
Your finances can get really complicated pretty quickly, so if you don’t have an accountant keeping track for you, I hope this article can help you shed some light on things.
In business very rarely are all things done on a cash basis. Service work is sometimes an exception to that if you’re a sole proprietor doing a short-term job, but for the most part you can expect to wait on your money. If you aren’t careful, you can get yourself into a cycle of high income, low cash flow and struggle to make ends meet.
What is Business Income?
Business finances typically work best on the accrual method rather than the cash method. With the accrual method you recognize income and expenses as they are earned rather than when money changes hands. The accrual method helps you to match expenses with income.
For example, imagine you pay someone $1,000 today to repair a car, then sold the car for $10,000 in 12 payments the minute the following month. For simplicity sake, lets pretend you have $0 in the car aside from the repairs. Based on the accrual method you would have an income of $9,000 from the transactions. You would also have a loan receivable of $9,167.
Using the cash method you would have a net loss of $1,000 in the month of the repair. In the 12 months following you would have an income of $833 per month.
If you have a business with multiple transactions every month, cash method can get really difficult to tell whether or not your business is successful very quickly.
Here is a quick glance at what cash method may look like in running a car lot. ( G & A removed for simplicity). Assume each vehicle costs $10,000 to purchase and the initial vehicle cost only the repairs and parts. Purchases are made on account and paid at $500 per month. Each vehicle is sold for $15,000 on payments of $1,000 per month.
Does this look like a profitable business? After three months your net income is negative and you’ve yet to see a good month.
Accrual method is different in many ways from the cash method. Sales are recognized as income when they are made and a receivables item is created if the cash isn’t delivered at the point of sale. Inventory comes into play on a more detailed scale as well but that’s a topic for another day.
So what would this exact scenario look like in the accrual method? Well, below are the entries that would have occurred.
This is a vastly different picture. In truth this business is very profitable. In the first quarter it earned a net income of $23,600. Who wouldn’t want to earn that in their first three months of business?
So you know I’m not just throwing numbers out there, here are the entries that make up these financial statements.
If you’re not an accountant these may seem like gibberish, but what you see here is the flow of your business. Equity, liabilities, inventory, sales, and cash are all lining up here to paint a picture of your business’s health.
So I Can Forget About Cash Flow Right?
Please don’t misunderstand. Cash flow is a vital part of your business success. Without knowing where your cash is going you can end up getting into trouble.
If you are only looking at your income statements then you see a hefty profit and it may be tempting to spend that income.
As nice as it would be to take out that money and go on a well earned vacation, the truth is you have $2,900 less cash than when you started.
I can’t tell you how many times I’ve worked with confused business owners who see that their making a killing, but have no idea why their bank balance is overdrawn EVERY SINGLE WEEK.
Other times a business owner may see a large balance in their account and go spend it while their income is in the gutter. They think they are doing great, then get hit with reality.
So How do I Handle My Business Finances?
Keep a close eye on your financials. Make sure you understand that cash flow and net income are two entirely different things in business. High net income is generally good. Low cash flow isn’t necessarily bad and high cash flow isn’t necessarily good. You just need to know what your cash flow is and optimize it for your business.
High cash free cash can mean you aren’t investing back in your business, or it can mean you’re being cautious.
Low free cash can mean you’ve put a lot into inventory, advertising or something else that will come back and then some. It can also mean that you are struggling.
Not knowing your cash flows absolutely means that you are in a vulnerable position. If you know your books, that is fantastic. If you don’t, then you would be well served to find someone to help you who does.
Let me know if you would like me to go more in depth on financials. Drop a comment if there is another topic you would like me to cover!
Next we will be looking at how you can develop your competitive advantage.