As a small business owner, it’s important to recognise that there is a difference between cash and profits. It’s one of several accounting concepts you should have some knowledge about in order to know what to keep an eye on.
Difference between cash and profit
So, the first question to ask is what is the difference between cash and profit?
Cash versus profit
Cash is like air; profit is like food. You need cash all the time, but you can survive — for a while — without profit.
Certainly, profit is essential for a business to grow. If there is no profit being generated over the long-term, the company will disappear. But also, it is a fatal mistake to overlook your cash position. Cash is necessary for the short-term survival of the firm.
Cash vs profit example
Suppose you’re making sales of £100 and you pay for stock of £50 and have other expenses of £40. This leaves you with £10 as profit. You’re pleased; you’re running a profitable business, and you think if you double everything you’ll make twice as much.
However, in order to make a sale, you’ll also need larger stocks. Currently, you have stock worth £200 and you’re making sales and using £50 of that stock in the sales. Now, for the larger sale, you have to put another £200 in to have twice as much stock. However, you may have to rent some additional space to store it, and you may need to spend more on finding clients… and the money for all that goes out before you’ve made any additional sales.
Your sales might go up to £200, but your cost of sales increases to £100. Your profits may be double or more, but the money you had to pay for extra stock and to recruit and train salespeople and any other costs has increased and gone out months before you start selling — not to mention the fact that some people don’t pay until months after a sale. We have to make sure we have a strong enough cashflow to cover the period while not being paid.
How to pay attention to both cash and profit
Avoiding a critical oversight of either cash or profit requires multiple things:
1. You need a strategic plan
Where do you want to go? Where would you like to be? This is the “dreamer” or vision phase of business planning; it’s necessary – though certainly not enough – to fuel a business.
2. You need a budget
You can use your Profit & Loss (P&L) from the last six months to determine a budget for the next six months.
You must determine whether the business can be profitable before you even worry about cashflow. Without profit, a business will never survive long-term.
3. You need a cashflow forecast
Budgets tell you if your expansion will be profitable and how much profit you will make. But they don’t tell you when cash is coming in. That’s where the cashflow forecast comes in.
The bottom line:
Cash is not profit, and profit is not cash. You need both to sustain and grow a business, though not in equal measures at every point.
But you never start with the cashflow.
The vision starts a business, profitability helps it grow, and cashflow is the day-to-day driver.
As long as you have enough cash to survive, you can comfortably expand to a more profitable business.
Why is cashflow important?
It’s important to have a positive cashflow so that your business can cover its everyday financial obligations, e.g. staff wages and rent. This is called working capital. A business with a positive working capital will have more money coming in than going out, indicating a healthy financial status. Without this, a business won’t be able to cover its costs, which could lead to financial disaster. Basically, you should be able to see how much you owe, how much you’re owed and how much you have in the bank.
What can cause cashflow issues?
If there is a significant delay between invoicing and receiving payment from clients. Say 90 days or more.
If you pay your suppliers quite quickly. Say within 30 days.
Not having control over your business spending.
Not assessing your cashflow and spending on a weekly basis.
1. Use the latest accounting software
Modern small business accounting software is remarkably easy to use and can free up an enormous amount of time.
Importantly, it also gives you real-time reporting on your cashflow, using a series of dashboards.
You can see who owes you money, check your bank account balance or how much VAT you owe, generate cashflow reports, and view performance against budget.
2. Credit control
An efficient credit control system saves time, speeds up your cash collection and reduces bad debt.
Before you grant credit, all new customers should be checked and re-checked once a year. Circumstances can change.
Control how much credit you provide and to which customers
Send out invoices immediately after you have supplied the goods or service
Monitor and chase late payments
Collecting money that is owed to you comes down to good systems and a lot of persistence.
If you are paid by invoicing your customers, start by getting the invoice details right. Does the customer require a Purchase Order number from its finance department? Have the payment terms and other details been agreed?
Issue invoices promptly and follow up on them regularly before they are due, especially for large amounts and poor payers.
The person who does the credit control for your business really needs to care about getting invoices paid on time.
3. Stock control
If you sell products, you may have to spend heavily on stocks of the items you sell. Set up appropriate stock control systems to limit the cash requirement.
Are you attempting to sell too many products? Would customers be happy with a choice of 10 colours instead of 25?
4. Build up a cash reserve
We all know that businesses have ups and downs. You might lose a major customer. Another customer may delay payment. Another may go out of business, owing you money.
Similarly, you might lose a key member of staff, or your IT system may go down.
Building up a cash reserve helps you deal with these stumbling blocks.
5. Controlling expenditure
If you know the current best prices and service levels, you can insist on better terms from your suppliers.
Consider whether you could make savings by purchasing some types of capital equipment second-hand.
Implement simple cost control systems
Easy savings can usually be found. For example:
overcharging by your suppliers, such as double billing or missing discounts;
unnecessary costs, such as heating your premises at night;
excessive costs, such as high-priced services that can be sourced more cheaply;
inefficiency, such as laborious paper-based systems which could be computerised.
At least once a quarter, do a line-by-line deep dive into your profit and loss statement. Look for unused subscriptions, excess office expenses, and any duplications in services that you can eliminate to improve your cashflow without harming your business’s efficiency.
6. Funding options
Only use overdrafts for short-term cash requirements
- Where possible, longer-term financing should be in the form of loans or other alternatives.
- Bank borrowings may be limited by the security you can give the bank.
Factoring allows you to raise finance based on the value of outstanding invoices
- Growing businesses in particular often find that factoring provides a more substantial and flexible source of working capital than overdrafts or loans.
Consider using asset finance to purchase computers, vehicles, plant and machinery
- Hire purchase or leasing allows you to spread the cost of the purchase, with the asset itself providing the main security.
- Consider generating cash by selling assets and leasing them back. Before doing so, check the impact on your profit and loss account.
7. Increase your prices
When a customer buys a product or service, they consider a number of things in addition to price. If you provide your target customers with the results they value, then price doesn’t factor heavily in your customers’ purchasing decisions. Determine why your customers buy from you in the first place, and then amplify those reasons in your marketing and sales communications to decrease price sensitivity.
Increasing your prices lets you improve your total sales without additional investment on your part, making it one of the most effective ways to improve your cash inflows while also improving your profit margin.
8. Upsell to your existing customers
It’s easier to sell to a customer who has purchased from you in the past than it is to acquire a new customer. It’s also less expensive to keep a customer than it is to get a new one. If you aren’t offering new or complementary products and services to your existing customers, you are missing out on a key opportunity to improve your cashflow.
Like with price increases, upselling to your existing customers typically requires little to no additional investment on your part.
9. Incentivise your customers to pay faster
Consider a cash payment or early payment discount (make sure you aren’t dipping into your profit margin if you do this) to speed up customer payments. If you don’t want to extend discounts, simply including a credit card payment link on your invoices can speed up collection significantly. The improvement to your cashflow will usually offset the cost of accepting a credit card payment.
10. Lease, don’t buy
Whether it’s a piece of office equipment or a new vehicle, consider leasing instead of buying. Leasing can help you always have the newest—and most efficient—equipment on hand without shelling out a lot of cash to acquire it.
Another benefit of leasing is that the lessor will often cover repairs and maintenance as part of the lease agreement, saving you money and improving your cashflow in the long run.
11. Ask vendors for extended payment terms
Asking for terms beyond the typical Net 30 (payment due within 30 days of the invoice date) for large purchases will keep you from taking a big hit to your cashflow all at once. Extended payment terms also give you more time to sell the product before the payment is due to your vendor. Many vendors are happy to extend 30/60 or 30/60/90 payment terms to their loyal customers.
If your vendor doesn’t offer extended payment terms, ask if they will offer you an early payment discount instead. Your cashflow will still take a temporary hit, but your overall payment will be lower.
12. Buy in bulk – even if you’re a small business
Vendors love large orders and often offer pricing discounts to customers who buy in bulk. Many small business owners think they can’t take advantage of bulk discounts, but with some creative thinking, even the smallest businesses can enjoy large-business discounts on materials and supplies.
13. Get efficient
The less time you spend producing a product or delivering a service, the more profitable your business is. This is especially true if you have employees you pay by the hour. Working to improve efficiency will not only improve your bottom line, but it will also improve your cashflow.
Consider upgrading any old equipment, invest in technologies that minimise duplicate efforts through automation, and explore performance incentives to help your business become more efficient – and more cashflow positive.
How to keep on top of your cashflow
Ensure your financial records are adequate and updated regularly
Carry out financial health check of your business at least every quarter
Regularly review and update your budget
Regularly review your accounts receivable aging report and follow up any late repayments
You need to act quickly and decisively if you are to stop short-term cashflow problems spelling the beginning of the end for your business.
Many small businesses overlook small changes they can make in their business. In reality, a combination of small changes in inflows and outflows can have a massive impact on your overall cashflow. However, if you do find yourself in a difficult situation, it’s important not to panic or ignore it.
Get in touch if you would like me to help you identify ways in which you can make some changes to your business to improve your cashflow.