Profit vs Cash Flow – Why you should care and how to improve both!
Editors Note: Expert content needs an expert content writer and Yorkshire Powerhouse is pleased to publish this business advice article on SME Accountancy and Management Accounts, kindly written by a real expert in her field – Victoria Wainwright, Managing Director of Naylor Wintersgill.
Please consider contacting Victoria for any aspect of accountancy, tax advice, bookkeeping or cloud accounting – just click on the advert links above or below – and please mention Yorkshire Powerhouse if you do make contact.
As a business owner, you ‘should’ recognise the difference between profit vs cash flow but, in fact, many small businesses don’t actually understand how fundamentally different these two things are and frequently focus on the wrong thing!
Just to make the bluntest of points – generally, a business can ‘survive’ (for a while anyway, and frequently indefinitely) even when it’s not making a profit, so long as it’s breaking even. HOWEVER, any business with poor cash flow (even if it makes a perfectly good profit on paper) is ultimately going to struggle to pay its suppliers, staff and bills and it’s unlikely to last long.
The #1 reason for business failure is negative cash flow.
Profit vs Cash Flow – The Basics
You’ve probably heard the old adage; “Turnover is vanity, profit is sanity, cash is reality” so let’s break this down and understand it a little more:
Your turnover figure is simply the total income you generate from sales to customers. There is a ‘worth’ in measuring turnover – mainly when you compare one period to the next or one year to the previous. It is a simple measure of your ‘volume’ of sales. BUT, other than that, it’s fairly pointless as a measurement metric … but it’s great for your ego when you’re enjoying a revenue growth period.
There are two general measures of profit that a small business should care about – gross and net. Gross profit is calculated by deducting the ‘cost of sale’ from your turnover figure. So, if in one month you sold 1000 pairs of socks for £3000 and the socks cost you £1000 then you have made a gross profit of £2000.
Net profit is more important and is calculated by deducting the expenses, salaries and overheads of running your business from the gross profit. So, following the above numbers, if in that month, your rent was £500, your general bills for marketing/admin/insurance/bank charges/deliveries/etc came to £500 and you paid a part-time member of staff £750 then your net profit comes down to just £250 – not much left from £3000 turnover or for your own retirement fund!
Following the above numbers/example, this business can theoretically ‘survive’ for as long as the business owner chooses to ‘not’ take a wage but that’s about it! HOWEVER, let’s say that the owner is offered a bulk lot of 10,000 pairs of socks at an amazing price (say £8,000 – 20% cheaper than normal) and they are also offered payment terms to take 60 days credit before paying. Here’s the result:
Month 1 – They sell their usual 1000 pairs of socks for £3000 and their overheads/expenses continue to cost £1750 – cash gain is £1250
Month 2 – Same as month 1. Cash gain £1250 – so, both months have now contributed a total of £2500 in cash.
Month 3 – Sales and overheads remain the same but you’ve now got to pay your supplier as the 60 days credit period has passed … so although you might gain another £1250 cash in month 3, you’ve got to also pay your supplier £8,000 … Ouch, you’ve now got to fund this yourself to the tune of £4250 – and it takes this business model 17 months of trading to generate that much spare cash!
Sure, you’ve got shelves full of stock but you’re now in trouble for survival – that’s the harsh truth of cash flow catching you out.
Monitoring cash flow
There is a single measurement of cash flow that should be at the heart of every business model … the bank balance. More importantly, the difference in the bank balance between this period and the previous, this quarter to last quarter, etc.
But many businesses focus on looking at their profit and loss report and fail to focus on cash! That’s why they are almost always surprised when they ‘suddenly’ end up talking to an insolvency practitioner!
So – the story here is to keep on top of your bookkeeping to allow you to look at your sales and performance … BUT, to also use basic cash flow forecasting to understand whether you have pinch points coming up. And, if you do, you can start planning to deal with them now rather than being surprised when you’re suddenly struggling to pay your staff!
What can be done to improve your financial control?
Proper financial control of a business should focus on the following 7 core elements if they want to really have a grasp on things.
4 x Profit improving elements:
Pricing – can you increase your pricing without losing customers. So, with the sock example above, can you sell your socks for £3.25 per pair rather than £3.00?
Volumes – can you sell more? If you can increase your sales then you will generally make more profit as some of your costs won’t increase (rent, etc) – so, can you do things to persuade a customer to buy three pairs of socks rather than one.
Margins – Take a look at your cost of sale (the cost of the socks). Is there any way you can get your supplier to improve on the price you pay?
Overheads – Often one of the easiest and quickest areas of improvement – take a long hard look at every single expense and overhead in your business – where can you find gains or savings. Every £1 you ‘don’t spend’ is pure and simple profit.
3 x Cash improving elements:
Receivables – (cash collecting) every single pound that a customer owes you is cash you are missing. This is more relevant in businesses that offer credit to customers but it’s still important.
Inventory (stock) or Work in Progress – The less time stock sits ‘in’ your business the better your financial performance – hence the ‘lean manufacturing’ concept of ‘just in time deliveries’ for components and parts being served to a production line. The same applies to a service business where your project takes ‘x’ months and you have agreed to interim invoicing or stage payments … it’s essential to be on the ball for these elements.
Payables – (suppliers) any opportunity to take longer to pay suppliers (with their agreement) is an elemental benefit to your cash flow.
Additionally, take a leaf from Alan Miltz and embrace the ‘Power of One’ concept … if you only improve each of these above 7 elements by 1% then the compound effect of this can be startling!
Just take a look at the graphic below where we have modelled a basic 12 month projection and only improve 3 elements by 1% per month … the end result is a DOUBLING of your net annual profits!
Profit vs Cash Flow – Summary
We often hear business owners ‘celebrating’ their profit growth or revenue improvement but we rarely hear of cash flow improvements. But, remember, cash is reality. Do everything you can to improve your profits and your cash flow and you’ll be on your way to a strong, stable business.
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Blunt advice on Profit vs Cash Flow from Yorkshire Powerhouse
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Management accounts provide a vital insight into the financial health of a business and allow you to understand your numbers and plan for the future