Have you been wondering why your business feels like it’s making healthy profits, but it feels like you never have any cash in the bank? Then this article is for you.
Before we get into the difference between these two concepts, we’ll cover some financial reporting basics. At the end of your financial period, your accountant will generally provide you with a balance sheet, income statement and statement of retained earnings and, sometimes, a statement of cash flows.
THE BALANCE SHEET
The balance sheet deals with the assets that you own and debts that you owe. Examples of assets include your bank account, equipment, items that you have prepaid as well as sales amounts that you are expecting to receive but haven’t received yet (otherwise known as accounts receivable). Examples of debts are credit card bills, bank loans, and money received from clients for a service you haven’t provided yet. They also include other bills you have outstanding (a.k.a. deposits and accounts payable).
THE INCOME STATEMENT
The income statement looks at the number of sales that you have earned during the year minus the expenses that you have incurred to earn that income. This depends on the type of business you have. For example, in retail, you might purchase inventory to make that sale and that cost is subtracted from your sales to calculate gross margin.
There are some other deductions on the income statement, such as amortization/depreciation on equipment purchases (both non-cash expenses). This article just covers the tip of the iceberg for these rules. However, it’s important to note all expenses listed on your income statement aren’t necessarily cash amounts paid during the year.
The statement determines your profit or loss for the year at the end. This then shows the starting point for your tax return for that year.
STATEMENT OF CASH FLOWS
The statement of cash flows is divided into three sections: operating, investing, and financing. This looks at how much cash you had at the beginning and end of your fiscal year and shows you what was spent in each area.
Operating refers to cash received/spent in the sales and expense categories of a business. Investing looks at any purchased or sold equipment or portfolio investments. Lastly, financing looks at the amount of extended or repaid loans during the year.
Since non-cash expenses, like amortization/depreciation, don’t affect the company’s cash position during the year, they get added back.
Most small businesses don’t require a statement of cash flows. Most of their activities fall under the operating area and investing activities that occur fewer and farther in between.
Now we know profit is a mix of the company’s financial results that include primarily cash and some non-cash items over a period of time. Cash flow on the other hand looks primarily at how much cash you have now and takes into account that cash can cover your upcoming bills. On the other hand, maybe you’ll receive cash to cover those bills. The balance sheet lists the amount of bills that you have to pay and cash that you expect to come in.
The Importance of Cash Flow
Cash flow can make or break businesses. Make sure you’re aware of how much cash you have in the bank now so you can cover the bills. Cash flow is also all about timing. You may have a client who will pay you $30,000 for an invoice in two months’ time, but have the same amount of debt due today and no other cash on hand. If you plan right, some of those bills could be foregone and purchased later or the due date for your invoice could be moved up through your terms.
Terms of Sale
The terms of sale listed on your invoice are an important aspect. What we mean by terms are the number of days that you give clients to pay their invoices. As a business owner have the freedom to set your own terms as there are no standard terms to follow.
Commonly used terms include, “Due on receipt” and “2/10, net 30”. If you see “due on receipt”, then the payment is due on the same day the invoice is issued. The term 2/10, net 30 has a lot packed into so few characters. First, let’s dissect “2/10”. It looks like a fraction, but for accounting, this means that you’ll be offering a discount of 2% if your customer pays their invoice in 10 days. The “net 30” portion means that the customer has 30 days to pay their invoice if they are not taking the discount. A different variation of this can be “3/5, net 60” meaning a 3% discount if paid in 5 days. Otherwise, the invoice is due in 60 days or just “net 15” which states there are no discounts being offered and the invoice is due in 15 days.
A Note on Profitability
Sometimes there’s a disconnect when businesses are bringing in a lot in sales but your income statement is saying otherwise. When this happens make sure that you have a good sense of your costs. First, we suggest looking at your expenses and making sure that they’re all required to run your business. Or, check if there are some extras or nice-to-haves tucked away in there. Once you’ve done that, see if your gross margin can cover your expenses. In an ideal world, that would also include your expected profit. Then, if that’s still not working out the way you expected, you should look at the selling price of your product or the price of the goods you are selling. Lastly, you can look for grants that the government may offer. These include subsidies for hiring summer students or credits for hiring red seal apprentices.
Our first example is a company that brings in $15,000 a month. However, their operating costs are $18,000 a month. This shows that even though there are notable sales coming in the door, they can’t cover their everyday costs. Looking at expenses would be a good way to start. Here, we find redundant monthly software costs of $500 and unused additional phone lines, and other redundant expenses.
Our second example is a seasonal business. It’s run out of a home in winter and summer but had to shut down from mid-March to mid-May. They usually only add one or two more staff members each busy season. In the age of COVID-19, these would generally be their slowest months however in 2020, they were closed. You might think this year would have less profit than their 2019 year, however, while they were closed, their daily operating costs were minimal. So, even though their overall sales for the year have decreased, their profit was higher because they didn’t have to pay overhead costs for months that didn’t generate a lot of sales.
While both profitability and cash flow are important, make sure that you are watching the amount of cash that you have in the bank to make sure that you can cover your bills as they come due and that your company can make it through the hard times.
As always, come visit us with any questions or concerns.