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You Need Cash Flow Not Profit

Date - 05 February 2016/ Category - Facts Of Life
Facts of life

If you think making a sale will automatically make you rich then think again – who ever told you that businesses that make a profit on its sales don’t go bust is wrong.

There’s a quick lesson here. What’s in your bank account is your priority, not what your profit and loss account says.

Your accountant is wrong, your bank manager is right.

I get annoyed when people point to banks not lending and say it’s some sort of crime. It’s not, it makes perfect sense.

If you were a business with profits and great cash flow they would lend to you. If you have profits and no cash flow then they won’t.

The problem is more often than the businesses that have poor cash flow are the ones that want the banks to lend to them, and they make up the majority of businesses too.

Put simply, without any cash flow how does the bank know you’ll keep the doors open long enough to pay them back; after all you’re asking them to keep the doors open long enough for you to make a profit!

If you don’t have any cash today I don’t care how profitable you think you are, you can’t open the doors tomorrow.

As a basic rule then, if you’re going to run your own business you need to figure out how much staying open each day costs and keep enough in the bank to make sure it happens.

When you start out you’ll have grand ideas of beautiful offices and grand websites; but they cost money.

If you want to give your business a chance of standing the test of time, give it the gift of cash flow and reduce your overheads to a minimum.

Operate out of your bedroom for as long as you can, build a website on the back of a fag packet and avoid taking on any costs like the plague; in the long run you’ll thank yourself.

Profitable businesses go bust every day because of an overstretched cash flow. They might make a profit, but if they don’t have the cash to survive until they collect that profit then they are doomed.

Before I startle to whittle on I’ll cut to the chase and explain how profit and cash flow are different (hint – watch the cash at bank figure).

Day 1: Cash at bank £1000 (assume running costs of £100 a day)
Day 2: Order received for £10,000 – potential £5000 profit (cash at bank £900)
Day 20: Deliver product (cost £5000) + receive second order for £10,000 (cash at bank -£5900)
Day 40: Chase payment for order 1 + deliver order 2 (cost £5000) (cash at bank -£12900)
Day 50: Payment Received for order 1 (cash at bank -£3800)

So the question is. How long could you have kept funding that business if the £1000 was all you had?

Most people forget cash flow when thinking about how well their business is doing. Time and time again I see CEOs think on day 20 that they have made £10,000 profit and as a consequence start spending it.

Unless you’ve got your profit safely in the bank then it’s not profit at all, all you’ve taken on is a huge liability.

It’s funny to think of a sale as a liability, but that’s what it is; you’ve taken on risk and paid out precious cash without anything in return. What else could you have done with that cash?
Has that sale pushed your business over the edge?

So how do you survive?

Well before 2007 most businesses went to a bank and asked for a credit line to keep them afloat until they realised their profit (got paid), but now that’s not so easy.

When the credit crunch arrived lots of “paper profitable” businesses went bust simply because they could not afford the length of time it took to get paid.

Today without these credit lines then businesses have to manage their cash flow better.

They have to hold off paying their suppliers as long as they can (if you’re a small business getting paid on time is a rarity).

Another option is to change their payment terms, make them shorter or take deposits that cover the short term liabilities they incur to deliver products (that’s why plumbers ask for money upfront to cover materials, their liabilities).

Finally then they could do something even more risky, keep selling more and more.

Why is growth risky?

As you grow, you incur more and more liabilities. Not only do you have the costs of making products, but you have the staff and fixed costs that come with growth. It’s all ok as long as you keep on growing, but if you don’t then you’re sat with some huge overheads that eat into your cash flow quick.

Most businesses find that for the first few years all their “profit” is soaked up by growth, yet if too much money is soaked up that growth can hurt cash flow so much that it can break a business.

In reality then growth, can actually be dangerous.

That is of course unless you run a cash positive business (sadly most businesses are not cash positive).

You see if you make something and then sell it, getting paid at the end, like most businesses you incur a liability until that profit is realised.

But what if you get paid in front? Then you can realise your profit straight away and avoid incurring a liability; this is a cash positive business.

In fact cash positive businesses don’t just survive rapid growth, they have cash left over; simply kicking around to invest in other projects making them very attractive to investors.

That’s exactly how Warren Buffet grew his net worth to $77 billion, he bought cash positive businesses like insurance companies so that he could use the spare cash generated to keep his highly profitable but cash poor businesses afloat until they could realise their profits and make him very wealthy.

Chapter Summary:

• Cash flow is more important than profit
• Cash keeps the doors open
• You need to keep your overheads low
• Growth can be dangerous
• Cash positive businesses are best

Read our next blog post “Everyone has flaws”.