After 15 Years in Accounting the Most Important Lesson I’ve Learned Is That Profit Is Important, but

Many small business owners can attest; they know how to make a profit, but managing their cash flow is a different story. It may not seem as important as the “bottom line,” but proper cash flow management is one of the biggest predictors of success. Unfortunately, it is commonly overlooked and oftentimes misunderstood until you realize that your business is in a cash crunch! Absent any other sources of cash (i.e. outside investment, owner contributions of capital, bank loans), prudent management of net cash from operations is paramount. Even if other outside sources of cash are available, optimizing the use of your cash will ensure investors and owners receive a requisite return on investment, the bank is paid in a timely fashion and your business is sustainable.

One common pitfall of businesses is to equate profitability with available cash. Sure, profitability can translate into available cash and healthy cash flow, but this isn’t always the case. We’ll look at an example below.

Example: Thirsty, Inc.

In this example, our business owner runs a beverage distribution company, Thirsty, Inc. Thirsty, Inc. uses an accrual basis of accounting, which means that revenue is booked when earned (not necessarily when payment is received) and expenses are booked when incurred (not necessarily when paid).

It’s the middle of a hot summer and the owner of Thirsty, Inc. has just started distributing a new beverage called “Ice Cold.” Customers are loving it and for the month of July, Thirsty, Inc. ships $50,000 of this beverage to customers, giving them 45 days to pay. Eager to see how the new beverage has affected profits, the owner looks at the income statement and is pleased to see that Thirsty, Inc. has a net income (profit) of $12,500 for July. The owner is happy with the reported performance and plans to use a portion of the profits to buy more Ice Cold for August, which is predicted to have record-breaking heat. When the owner tells the accounting department that he wants to place an immediate order for more Ice Cold, the accounting staff notifies him that cash is tight and there are not enough funds to replenish inventory to accommodate the growth in sales. What happened? How can cash be tight when profits are high?

Here's how it works. Under accrual accounting, Thirsty, Inc. is reporting revenue on their income statement when it is earned (i.e. when it is shipped to their customer). However, Thirsty, Inc. did not require their customers to pay until 45 days after the invoice date. So, while Thirsty earned profits in July, they need to wait 45 days (assuming no customer pays early) to see the payments appear in their cash balance. Since the accounting department stated that they don’t have adequate cash to fund the necessary inventory purchases, they must wait 45 days to buy more Ice Cold.

Thirsty, Inc. is now in a tight spot. They need to buy more beverages so they can meet their customers’ demand for Ice Cold, but they can’t afford to buy enough inventory until their customers pay. Thirsty, Inc. will likely have poor performance until they can build up their cash reserves. Bigger problems loom in the background. If Thirsty can’t meet customer demand, these customers may seek a different distributor. Secondly, if the above issues result in low profits in the coming months, cash will likely get tighter, which may not only make it hard to buy more inventory, but also to pay their operating expenses like salaries, rent, utilities, etc. Once this cycle starts it can be hard to stop, so you can see how quickly a lack of cash can have significant impacts on a business in the short and long-term. If Thirsty, Inc. doesn’t make changes to their operating procedure quickly, they may be out of business soon! It seems strange, but without proper cash management, even a business that has a good profit margin and a demand for their products can end up having to shut down.

Lessons Learned

Many small business owners learn this lesson the hard way. If there is any anticipated lag between reporting sales and getting paid, forecasting cash flows is essential to ensure the business has adequate funds to continue running.

Oftentimes, small businesses have less leverage than larger ones, so they need to pay their suppliers much sooner than their customers need to pay them (i.e. Thirsty, Inc. needs to pay suppliers in 15 days, but customers pay Thirsty, Inc. in 45 days). The result of this lack of leverage is a potential for a cash crunch as illustrated above. This example can be exacerbated when inventory is purchased and sits on the floor of the warehouse for weeks or months before it is sold (i.e. slow-moving inventory). We’ll examine this topic in future blog posts about managing slow-moving inventory and how to improve the cash conversion cycle (how quickly Thirsty, Inc. can convert cash on hand into inventory and back into cash).

For now, pay closer attention to your cash flows and forecast your revenue, expenses, and other purchases (i.e. inventory) to ensure you always have enough cash to keep your business afloat. If you're still confused by what impact all this may have on your business or if you'd like to start planning cash flows, but don't have the time, we at Polaris Tax & Business Services are happy to help. Contact me anytime and I'll be glad to chat with you about your business.

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