When I first sat down to write this article, we were living in a pre-COVID-19 world. A world where businesses were growing, starting, and some beginning to face some distress – a usual business environment. While the environment has changed, the underlying themes in this article are still applicable although the situation that your business in may be different now.
One thing the many businesses, and especially new businesses and businesses that are growing fast, misunderstand is the difference between profit and cashflow. Just because your business is making a profit doesn’t mean it has sufficient cashflow to sustain itself.
When you are profitable, you may have blinkers on and think in simplistic terms, for example, if I double what I’m doing now, I’ll make twice as much profit. You may spend money on expansion buying new equipment, or diversifying markets or geographies, hiring more staff, and so on. Conversely, when there is no profit being generated over the long-term, the original investment in the business is being eroded.
Crucial difference between profit and cashflow
Profit (also known as net income) is the surplus after all expenses are deducted from the revenue. Cashflow, on the other hand, is the amount of available cash within a business at any given time as a result of the inflows and outflows.
Profit is looked at over a period of time and is usually backward looking. The ‘profit or loss for the period ending’ is the usual heading on a ‘Profit and Loss Report’. Cashflow is forward looking and more immediate, for example, the cash forecast for the week or month ahead. It is the lifeblood of the business.
Which is most important
To determine which is more important, you need to consider the circumstances and type of business. Business A may make a profit every month, or even see increasing profits, but all their cash is tied up in working capital or fixed assets.
Cash, therefore, is extremely tight, and employees wages, creditors and taxes are difficult to pay on time. However, because the business is generating profits, they may be able to borrow cash to help their liquidity. Here, cash is more important as it keeps the business running while still maintaining profits. Some of the tech companies such as Facebook and Google were good examples of this.
Alternatively, a business may see an increase in revenue and cashflow, but it is carrying a substantial amount of debt and has large depreciable assets, so the business does not make a profit.
To me, though, cashflow is more important – you can make a profit without cashflow, but your business will not survive. Conversely, you can make a loss and survive if you have a positive cashflow. Fred Adler, the famous US venture capitalist had a series of epigrams known as Adler’s Laws. One of my favourites is "Happiness is a positive cashflow". Adler believed that to have a successful business, in fact, he said, was vital for business success, was:
- Being able to generate more cash than was being spent
- Having the cash where and when you need it
- Happiness is a positive cashflow
For these reasons, it is often the small- to medium-sized business that are at the highest risk of being ‘cash poor’ as they constantly reinvest cash into the operations. More established and larger businesses frequently have a cash reserve or the ability to obtain cash quickly.
Another of my favourite epigrams by Antoine de Saint-Exupéry is a "A goal without a plan is called a wish". Every business needs a cashflow forecast and to understand the cash-to-cash cycle and the length of that cycle well. A cashflow forecast will not only help you manage your cashflows, but will also give you a much better insight into your business.
It will show the pipeline of sales and debtor receipts you need to generate to cover the cash outflows, which debtors to manage more actively and which creditors you need to negotiate better payment terms with. It will make you more aware of the overheads and where cash is being spent and focus your attention on the level of sales and margins required to cover the outgoings.
Cashflow and profits are both crucial aspects of a business. Over the long-term, a business needs to generate a profit while also operating with positive cashflows. Reverting back to the situation we currently face with COVID-19, the cashflow is probably the main area I would be focusing on as a business owner.
If you are forecasting a revenue decline, then look at your overheads now. Cut hard and fast, and then grow incrementally and slowly. Look at ways to diversify the sales streams. But focus on cashflow at the moment and not profit.