Five Financial Mysteries Revealed
Over 800,000 new small businesses are started every year. This number is projected to grow to 1 million per annum by 2010 (U.S. Small Business Administration). Here's a very important question: How many of these new owners understand the financial fundamentals of their business? The answer is, I'm afraid, not nearly enough. It's one of the biggest and most dangerous management deficiencies in the small business sector, and unfortunately, it's not just a start-up problem.
The reason for this deficiency, I believe, is that many small business owners, even many of those with college degrees, have no practical or educational accounting background. But the problem is more than debits and credits, it's understanding the relationship between the two most important financial dynamics in any business: cash flow and accounting.
If I were forced to use only one word to help a small business owner understand the difference between cash flow and accounting, that word would be "time". More specifically, the way the marketplace uses time. Marketplace time is important to understand because it is not only the difference between cash flow and accounting, it also binds the two together.
As you read this article and other discussions of business finances, notice how many times (no pun intended) the word or the concept (days, annual, depreciation, amortization, incremental, period, etc.) is used.
What follows is my attempt to identify and explain what I consider to be five prominent financial mysteries that create problems for small business owners. My goal is to introduce these mysteries and give you some informational seeds that you can use to grow a better understanding of your business finances.
Financial Mystery Number One: Cash flow and accounting are not the same things.
In its simplest terms, accounting is doing the math on the relationship between all of the revenue you take in and the disbursements that go out. Inside of that math you "account" for the business by groups of activity, such as sales, inventory, various expenses, etc. The manifestation of all this accounting is a set of financial statements which will help you manage your business, and provide proper reporting to others like your banker, and the taxman.
Profit is accounting, not cash.
Cash flow seems simple enough: You either have cash or you don't, right? But the way the marketplace uses time makes understanding cash flow tricky, as you will soon see. Our Brain Trust's business planning expert, Tim Berry, says, "Cash flow is not intuitive". Tim's right, and more's the pity.
Cash flow is cash, not profit.
If there were no taxes, and if everyone paid "cash on the barrelhead" (no "net 30" accounts), and if we didn't keep inventory, and a few other "ifs", then managing your business' finances would be simple: Marketplace timing would be eliminated, accounting would not be necessary, and your cash flow would reflect the true financial health of your business.
But such a business is fictional. Even a fourth grader's lemonade stand has inventory, which is the state of some of your cash during the time it takes to convert those goods (lemons, sugar, cups, etc.), back into cash again.
Bottom Line: The timing relationship between accounts receivable and accounts payable (more on this later), the repayment of debt over time, conversion of cash to inventory, and the timing of the tax treatment of certain assets, are fundamental reasons why cash flow and accounting are not the same things.
Financial Mystery Number Two: You can be profitable but not have positive cash flow.
Here's what this looks like: If you have to pay your suppliers before your customers pay you, your company may be profitable but someone else has your cash.
Here's what this sounds like:
Receptionist: "Boss, your banker is on the phone, something about being overdrawn."
You: "That can't be. I have my financial statement from my accountant in front of me and we're making a profit."
This is like the cartoon where Blondie couldn't understand how she could be out of money when she still had checks left? You both look good on paper, but you don't have the cash.
The profit you derived from your customers' purchases was "accounted" for on your financial statements, but the actual cash payment for that purchase may not happen (likely will not happen) until some time after the accounting period.
Bottom Line: Don't look at the profit on your Operating Statement (aka P&L, a/k/a Income Statement) and think that you can spend that amount. And by the same logic, if you post a periodic loss that doesn't mean you are out of cash. By the way, your banker is still on hold.
Financial Mystery Number Three: You can have positive cash flow and not be profitable.
Here's what this looks like: When you are on an open account relationship with your vendors but you are paid by your customers at or near the point of sale you will often have positive cash flow. At least for a while.
Here's what this sounds like:
You: "Man, this is great. I've never seen so much cash. There's nothing to this business thing. Making a profit is easy. Darlene, I'm going down to the dealership to pick out my new truck. And when the guys bring that new fixture, go ahead and write the check."
Assistant/Bookkeeper: "Hold up, Boss. Before you go, I just totaled up the vendor invoices for all of the stuff we sold this month. You might want to see this before you trade up to the King Cab."
You: "@!#*, this total is more than my cash! What's going on here?!"
In the twinkling of an eye, all of your so-called "profit" turned into your business being out of cash. And even if you actually are making a profit, it likely won't overcome the mismanagement of your cash.
Mystery Number Three is probably the biggest reason point-of-sale businesses fail (retail, restaurants, etc.), and it's an ugly train wreck when it happens. Did you ever see a restaurant open and close within 90 days? Probably had nothing to do with the food or service. They probably mistakenly thought their cash was profit and spent it. This is one of the reasons most start-up companies begin their relationship with vendors on a C.O.D. basis. If you don't understand Mystery Number Three, you might want to put yourself on C.O.D. until you do.
Bottom Line: Don't look in your checkbook to see how profitable your business is. And if you find a positive balance, it's just timing. Most, if not all of that cash is just waiting around to be sent to someone else.
Financial Mystery Number Four: You can get squeezed between your vendors and your customers.
Your vendors and your customers are the two entities that you deal with financially every day your business is open. Understanding your relationship between these two, (literally between, because your business is in the middle), is the key to cash flow management. The way to make sure that you don't get squeezed by these two parties is by managing your Accounts Receivable Days and Accounts Payable Days.
Accounts Receivable Days - This is the time that it takes you to collect the cash for the sales you have made on credit. Here is how you calculate A/R Days:
Divide the Accounts Receivable number on your balance sheet into your total sales for the period (this period is usually annual, but at least more than one month). Then divide that quotient into the number of days of the period.
Example: Annual sales are $600,000 ÷ $55,000 Accounts Receivable = 10.91. Then 365 days ÷ 10.91 = 33.46 Days Receivable. In this example, it took an average of 33.46 days to collect your receivables.
Accounts Payable Days - This is the time that you take to pay for your purchases. Here is how you calculate A/P Days.
Divide the Accounts Payable number on your balance sheet into your total cost of sales for the period (usually annually, but at least more than one month). Then divide that quotient into the number of days of the period.
Annual cost of sales are $450,000 ÷ $35,000 Accounts Payable = 12.85. Then 365 days ÷ 12.85 = 28.40 Days Payable. In other words, you paid vendors within 28.40 days.
Now let's look at the relationship between your A/R Days of 33.46 and A/P Days of 28.40: On average, you paid your vendors 5.06 days faster than you collected from your customers. In this example, and without any other cash resources, you will experience a corresponding period of negative cash flow.
And remember, this company could very well be profitable and growing. But for 5.06 days, the company will either have to rely on credit or working capital (See my "Retained Earnings article) or be out of cash.
Bottom Line: Don't get squeezed. Manage your A/R Days and A/P Days so that they are closer together. In the case above, if you were able to wait 2.53 days longer to pay your vendors, and could collect 2.53 days earlier, your cash flow shortfall would go away. Of course, the best plan is to get your customers to pay 5.06 days faster.
Financial Mystery Number Five: Profit is the Queen of Business, but Cash is King.
Does this sound like I am saying that having cash is more important than making a profit? Well, I am - sort of.
It's always important to make a profit. However, you may not make a profit every month or every year. You can work through an unprofitable period with well-managed cash flow, but even profitable businesses don't last long without cash.
Bottom Line: The most intense, anxious, and anguishing moments of your career as a small business owner won't be about not making a profit, it will be about being out of cash. Manage your business for profitability, but operate it for cash flow.
Write this on a rock... You can have positive cash flow without making a profit, and you can be profitable while being out of cash. You can survive either of these circumstances if you understand the way the marketplace uses time and the difference between cash flow and accounting.
