Profit does not Equal Positive Cashflow
It’s an odd statement, but it is a fact – profit does not equal positive cashflow. Profit is the result of a financial period (like a month) when your incoming revenue exceeds the applicable expenses. Cashflow is the way your income and expenses flow through your bank account. There is some connection between profit and cashflow, but unless you are using cash-based accounting, the two don’t have a parallel to each other.
So, what is profitability?
Profitability is retaining more income than expenses. Often, we look at a specific period, commonly known as ‘Month-end,’ and compare the actual income earned and the applicable costs for the month that operationally go against the earnings.
Profitability will look slightly different depending on the accounting method a company uses (accrual or cash-based accounting). To learn more about accrual-based versus cash-based accounting, click here. When possible, companies should use accrual-based accounting because it follows the matching-principle and gives you a much clearer understanding of the financial performance of your company.
The matching-principle (though highly recommended and sometimes required) is where cashflow can get confusing, so here’s an example. When accountants look at a financial period, let’s call it the month of July, we analyze all the July revenue-generating activities against all the applicable July expenses. Once the appropriate debits and credits are on the income statement, we happily report you made a $10,000 profit! To celebrate, you’re offering to pick up the tab at the local watering hole. Still, you remember the office building lease payment hits the business account on the 3rd of every month for $5,000, and the annual subscription for your company software will be auto renewed on August 10th for $7,000.
Now you don’t have to be an accountant to have noticed I said $10K profit for July, but $12K of expenses will be due within the next ten days, nervous? Well don’t be, you may have to be an accountant to have also noticed that only the appropriate debits and credits go to your income statement. The other debits and credits, (call them inappropriate for July), are the other transactions that could impact your cash flow but not your profit. For example, maybe you also had a $15,000 advance deposit received from a client for a big job starting in September; that should cover the annual software subscription, so drinks on you!
A little more on cashflow.
Cashflow is the movement of cash in and out of your bank account. Cash movement is due to any outgoing expense, (payroll, vendor payments, rent, insurance) and incoming cash (revenue, investments, refunds, advance deposits). These in and outflows will all relate to your business but may apply to various reporting periods, not necessarily the period they hit your bank account. These transactions are managed separately by your accountant on your balance sheet.
It’s misleading when you have a positive cash balance, but you’re not profitable. Be mindful that you can maintain your cash balance due to investors, personal deposits, and credit. Having investors is an important reason why your accountant must keep your balance sheet clean reconciled; it shows you the financial health of your business. You don’t want to misrepresent the reserves in the company, especially if you have investors. To maintain their trust and investment in your business, they will appreciate clean financial reporting.
Another tip: If you continue to be cashflow positive and not profitable, look at your payables and your deposits, you may owe money to clients and vendors. So, don’t interpret cash flow positively as an opportunity to spend. The balance sheet provides many opportunities to analyze your business, check out this article by Small Business Chronicles for The Advantages of the Balance Sheet.
Is profitability or cashflow more critical?
Both profit and cash flow are essential. Without cash, you may not be able to pay your employees. Without profit, eventually, cashflow will be negatively impacted. Ultimately, profit will be the deciding factor if a business will be able to sustain itself. Money is vital, but it can be borrowed and held for specific expenses if a company has cashflow concerns.
When reviewing your monthly financials, look at both the profit (or net income) on the income statement. Then, bounce this off the bank account balances on the assets side of the balance sheet. To read about more examples of why your profit and cashflow are misaligned, check out this article by Growthforce.
How do I avoid over-drafting my business account?
Your trusty accountant should have a cash flow analysis. This includes your forecasted cash balance through the next couple of months. It will allow you to see when payments (like payroll) hit the account so you can plan other purchases strategically if needed.
The cash flow analysis is also a big piece of the pie if you’re considering a large capital project or need more inventory. It will help you understand, as the business owner, how to plan business expenses. Also, how to strategically avoid overdraft fees or deferred credit card payments. If you continue to see large profits but minimal cash flow, be sure to take a look at your account’s receivables.
How do business owners ensure they know all this stuff?
First of all, they don’t know all this stuff, but their accounting team sure should. A business owner should have a good understanding of the financial fitness of their company. They should be able to use their financial statements along with their CFO or Controller to make guided business decisions. It is essential that a business owner has resources to call on when looking at finance. As well as HR, marketing, technology, and legal categories. These individuals can be on payroll or be consultants. The most important aspect is that they are trusted, transparent, and knowledgeable.
As a business owner, we recommend that you spend about an hour speaking with your Controller or an hourly CFO service to review your monthly financials. If you’re not doing this, the first few reviews may take more time, but with practice, they will shorten. Based on the size, financial fitness, and forecast a quarterly meeting may also suffice.
Based on the cadence of your review, you should receive at least three financial reports:
- Income Statement
- Balance sheet.
These three financial statements are all connected. Each will give you a comprehensive review of the financial health of your business, including profit and cashflow.
Call to action
Now with an overall idea of profit and cashflow, you need to move forward on a couple of things. So, here’s your homework:
- Schedule a call with your accountant and let them know you want to review your financial statements
- After the call, ask them to set up a recurring call on the 10th business day of the month to do a similar review
- After three months, make three financial goals with your accountant to achieve in the next 12 months
If you currently don’t have an accountant or one with the bandwidth to review financial statements and create goals with, check out our Bookkeeping tiers and Hourly CFO services. We can have a complimentary discovery call to see what will be most beneficial to you.