This is a question that we come across regularly in our consulting with clients.
The simple answer is that profit simply does not equate to cash!
There are many outgoings that you incur day to day that are not considered to be an expense in working out your profit. Such things as asset purchases, repayments of principal on loans and payments of income or company taxes are outgoings but are not an expense for the purposes of calculating your profit.
One of the biggest contributors to cash flow problems (apart from lack of profit) is the business owner’s personal expenses, which in many cases exceeds the profit earned by the business. This is particularly the case where the business bank account serves also as the business owner’s private bank account. In these circumstances, there is no control over private expenses. Typically we find that if business makes $50,000 profit, the owner spends $60,000. Then, if it earns $100,000, the owner spends $110,000! Recently we encountered a client who was spending over $130,000 a year just because the business account was their private account as well. They thought they were spending only $50,000 a year – certainly a shock for them when we told them (and cash flow was really tight – and no wonder!)
Further, if the business is growing, funds are also required to be invested in growing inventory and accounts receivable. All these factors are a sure sign of impending disaster, all the while making a profit!
The answer to this issue includes:
- Preparing reasonable financial forecasts for the business, updated regularly
- Having a separate private bank account from which all private expenses are paid from
- Establishing a reasonable regular budgeted wage/draw from the business to your private account
- Having and enforcing credit policies
- Managing inventory levels
- Considering financing major asset purchases
For a sustainable business, a profit is essential. However, without adequate cash flow, a business will fail!
Now is the time to start working on your financial plans for next year and become one of the 10% of SME businesses that do this. Those that do put in place plans out perform the other 90%! Which do you want to be?