One of the most confusing situations for business owners is having a profitable business on paper but not having enough money in the bank.
You might look at your profit and loss statement and think, “We’re making money, so why does cash always seem tight?”
The answer comes down to the difference between profit and cash flow.
While they are closely connected, profit and cash flow are not the same thing. Understanding the difference is important for making better business decisions, managing your finances, and ensuring you have enough cash available to pay your bills when they fall due.
What is profit?
Profit is essentially what is left after your business income is reduced by its expenses.
For example, if your business generates $500,000 in sales and has $400,000 in expenses, your business has made a profit of $100,000.
Your profit and loss statement helps you understand whether your business is performing well financially over a particular period.
However, profit does not necessarily mean that $100,000 is sitting in your bank account.
This is where cash flow becomes important.
What is cash flow?
Cash flow looks at the actual movement of money into and out of your business.
Cash coming in might include:
- Customer payments
- Business loans
- Owner contributions
- GST or tax refunds
- Other income received
Cash going out might include:
- Supplier payments
- Wages and superannuation
- Rent and utilities
- Loan repayments
- Equipment purchases
- Tax payments
- GST and other ATO obligations
- Drawings or dividends
Your cash flow tells you how much money is actually available to meet your financial commitments.
How can a profitable business run out of cash?
Several factors can cause this.
1. Your customers haven’t paid you yet
Imagine you invoice a customer $50,000 in June, but they don’t pay you until August.
The $50,000 sale may be included in your financial results, but you don’t have that $50,000 available in the bank yet.
If you still need to pay wages, suppliers, rent and other expenses before the customer pays, your cash flow can become tight.
This is why accounts receivable and debtor management are so important.
2. You have purchased equipment or other assets
Buying a new vehicle, machinery, computers or other equipment can require a significant cash outlay.
The purchase may not appear as an immediate expense in your profit and loss statement in the same way as the cash leaving your bank account.
Instead, its cost may be spread over several years through depreciation.
So, you could have a profitable month while your bank balance has dropped significantly because you’ve purchased a major asset.
3. You’re paying off loans
Loan repayments can also create confusion.
The principal part of a loan repayment reduces your bank balance and your outstanding debt, but it isn’t generally treated as an expense in your profit and loss statement.
Interest, on the other hand, is generally an expense.
This means your cash can decrease by more than the expense appearing in your profit and loss.
4. GST and tax payments can create large cash outflows
Tax obligations can sometimes catch business owners off guard.
You may have a profitable quarter or year, but when your BAS, PAYG instalments, income tax or other obligations become due, a substantial amount of cash may need to leave the business.
Putting money aside regularly for these obligations can help avoid a nasty surprise when the payment falls due.
5. You’re growing too quickly
Growth is usually a positive thing — but rapid growth can put pressure on cash flow.
For example, you may need to:
- Purchase more stock.
- Hire additional employees.
- Pay suppliers before receiving payment from customers.
- Purchase equipment
- Increase your premises or storage.
- Spend more on marketing.
Your sales and profit may be increasing, but the cash needed to fund that growth can increase even faster.
A growing business can experience greater cash flow pressure than a slower-growing business.
A simple example
Let’s say your business has the following results for the month:
Sales: $100,000
Expenses: $70,000
Profit: $30,000
At first glance, this looks great, but imagine that $40,000 of your sales haven’t been paid by customers yet.
At the same time, you have paid $20,000 towards a new piece of equipment and $10,000 towards a loan.
Your profit may still look healthy, but the amount of cash available in the bank could be much lower than expected.
This is why looking only at your profit, and loss statement doesn’t always give you the complete picture.
How can you improve your business cash flow?
The good news is that cash flow can be actively managed.
Keep an eye on outstanding invoices.
Don’t let unpaid invoices build up.
Set clear payment terms, send invoices promptly and follow up on overdue accounts. The sooner you receive payment, the sooner that money is available to your business.
Prepare for upcoming expenses.
Look beyond today’s bank balance.
Consider what payments are coming up over the next few weeks and months, including wages, BAS, tax, loan repayments, insurance, supplier bills and large annual expenses.
Maintain a cash reserve.
Where possible, build a cash buffer into your business.
Having funds available for unexpected expenses or quieter periods can provide valuable breathing room.
Prepare a cash flow forecast.
A cash flow forecast can help you see what your bank balance could look like in the future based on expected income and expenses.
This can highlight potential cash shortages before they happen, giving you time to take action.
Don’t confuse profit with money available to spend.
This is one of the biggest mistakes business owners can make.
A business can be profitable without having spare cash available to withdraw or reinvest.
Before making large purchases, increasing drawings or taking on additional commitments, it’s important to understand what your future cash position looks like.
Profit is important. Cash flow keeps the business moving.
Profit tells you whether your business is financially successful.
Cash flow tells you whether you have enough money available to keep meeting your commitments.
You need both.
A profitable business with poor cash flow can still experience significant financial stress. On the other hand, a business can have strong cash flow for a period of time without being genuinely profitable.
The key is to understand what’s happening with both your profitability and your cash position.
At AJ Buckingham & Associates, we can help you understand your business numbers and plan, rather than simply looking backwards at what has already happened.
If you’re unsure where your business stands or want to improve your cash flow management, contact us on (03) 9435 4444 to discuss how we can help.
For further tips to improve your cash flow, click on the link below:
Improve your cash flow | Business Victoria
For a free cash flow forecast tool – click here.
