I am profitable but I am running out of cash. What’s up with that?
Sound familiar? Often, profitability is confused with cash flow in the business world. However, those two measurements are not synonymous. So what’s the difference?
Let’s start from the beginning with some basic terminology:
BALANCE SHEET is the measurement of a company’s resources (CASH is one of those resources). A basic balance sheet has three components: assets, liabilities and equity.
- ASSETS | the “stuff” you own or is owed to you. For example, cash, receivables, inventory and property and equipment are all assets.
- LIABILITIES | the “stuff” you owe. For example, accounts payable, credit cards payable, gift cards outstanding, notes payables, sales tax, payroll taxes are all liabilities.
- EQUITY | the businesses worth (the balance of assets less liabilities). Typically, equity is comprised of common stock, paid in capital, contributions/distributions and retained earnings (the accumulation of net earnings over the life of the business).
PROFIT & LOSS is the measurement of a company’s PROFITABILITY. A basic profit and loss has four components: sales, costs of goods, operating expenses and other income/expenses.
- SALES | the gross proceeds received from the sale of a product or service.
- COST OF GOODS SOLD (COGS) | the cost incurred directly related to the sales generated. These typically vary based on the level of sales. Here’s an example: the purchase price of inventory sold or labor and materials in a manufacturing process.
- OPERATING EXPENSES | the normal, ongoing costs incurred to conduct your business. Think office wages, professional fees, office supplies, bank fees, and advertising.
- OTHER INCOME AND EXPENSES | the sources of income earned and expenses incurred outside of the normal course of business. More examples? Gains/losses on investments.
PROFITABILITY is what’s left after deducting all of the business expenses from the income generated. Still not sure what that means? Let’s break it down …
SALES – COSTS OF GOODS SOLD – OPERATING EXPENSES ± OTHER INCOME/EXPENSES = NET INCOME (PROFITABILITY)
Still with us? Now here’s how cash flow works (and no, they’re not the same).
CASH FLOW is the difference between the cash at the beginning of the period and at the end of the period. At its simplest form, cash flow equals the cash changes in assets (other than cash itself – that’s what we are calculating), liabilities and equity. Cash flow is provided or used by various activities of the business. The activities are broken into three categories: operating, investing, and financing.
BEGINNING CASH BALANCE
± NET CASH FROM (USED BY) OPERATING ACTIVITIES
± NET CASH FROM (USED BY) INVESTING ACTIVITIES
± NET CASH FROM (USED BY) FINANCING ACTIVITIES
= ENDING CASH BALANCE
- OPERATING ACTIVITIES | starts with net income (that’s right, profitability is a component of cash flow) and adjust for non-cash transactions. What non-cash transactions? The adjustments include, but are not limited to, depreciation, gains and losses on sales property and equipment, and bad debt expense. Once adjusted for the non-cash transactions, net income is adjusted for the changes in operating assets and liabilities. What are those? Operating assets and liabilities include, but not limited to, accounts receivable, inventory, prepaids, accounts payable, and accrued liabilities are added or deducted.
± NON-CASH TRANSACTIONS AFFECTING NET INCOME
± CHANGE IN OPERATING ASSETS AND LIABILITIES
= NET CASH FROM (USED FOR) OPERATING ACTIVITIES
- INVESTING ACTIVITIES | includes, but not limited to, cash payments to purchase investments, property or equipment or fixed assets. Or on the other hand, cash received from selling an investment (or receiving a dividend from an investment), property or equipment.
- FINANCING ACTIVITIES | includes, but not limited to, cash payments on long-term debt, cash received from issuance of long-term debt, net change (cash received and paid) on a line of credit, and cash contributions or distributions from owner.
All that goes into cash flow? Sure does. There are several other sources and uses of cash than profitability alone.
So if you have a lot of work and have sold a lot of your product or service, you may be really profitable. But, if your customers aren’t paying you in a timely manner, you may not have a lot of cash.
Or, in another scenario, if you took out a loan to start or expand a business, but you’ve been selling your services for less than they cost, you may still have some cash, but you aren’t profitable.
Moral of the story? They’re not the same, so don’t confuse them. You can have profitability without adequate cash flow. Or vice versa.
Seem like a lot to manage? We can help. Contact us about our CFO 2.0 services.