When people start out in business, they often think that as long as there is money in the bank, they’re doing ok. Unfortunately, this is not always the case.
Think about it for a minute. Do you look at your bank account and if there’s money in the account think that you’re ok, that you have enough to pay the wages, the rent and other bills you know are due? Certainly, having enough money in the bank account to pay those bills is great, but it may still hide issues in your business. On the tip side, if you don’t have enough money in the bank to pay the bills, you know you need to do something quickly to get money in the bank.
Making a profit means that your income is more than your expenses. However, you may also have loan repayments, hire purchase payments or need to buy equipment and assets. These costs are added to your expenses which means that you need to have enough profit to cover those extra costs as a bare minimum to keep the business viable.
Better still is to be making more profit than you need to cover the other costs so that you have a surplus. Even making that surplus profit doesn’t guarantee that your business will have good cash flow. The timing of your clients or customers paying for their goods and services is critical as is the timing of when you pay your bills.
Add to this scenario the cost of purchasing inventory if you sell products and you may find that you are making a good profit but your cash flow is like a rollercoaster ride and you’re regularly stressed out about whether you’ll have the money to pay the bills.
If you ask your accountant when you’re about to buy your next piece of equipment, you will most probably find that they will suggest that you take finance out on it. A former client of mine who makes good profits wanted to buy a truck to make deliveries rather than paying the delivery man all the time. The truck cost $ 120,000 and he had the money in the bank, so he could pay for it outright. The impact of doing this would have meant that he wouldn’t have had the funds later in the year to pay his BAS return or income tax on the profits. Rather than paying for the truck outright, the farmer took out hire purchase finance and kept the funds in the bank account to cover future costs and bills.
The difference between cash flow and profit is one of the least understood aspects of accounting. By preparing a budget which projects expected income and expenses will show your profit goals for the period. Using the budget, the next step is to then break down each item in the budget and put a time frame on when the income will be received and when the expenses and other costs need to be paid. This gives the cash flow projection.
Farmers particularly get the difference as they regularly spend money month after month to grow the crops and then only when the crops are harvested do they receive any income. In some cases, the income will only be for a percentage of the revenue and payments continue over a period of time. In other cases, the income is paid in full. This is why farmers often refer to the feast and famine of their finances as they may only receive income in 2 months of the year, whilst the other 10 months they are spending money. Keeping sufficient money from the sale of the previous years’ crop to fund the next years’ crop is an ongoing issue and when mixed with drought or floods or other natural disasters is the cause of many a farmer feeling stressed out about their finances.
Property developers have a similar situation where they are paying out the costs of purchase of the property and all the building costs and then only when the project is completed are they able to sell the property and get paid their income.
Builders are like most other businesses where there is an amount of costs paid out each month before they are able to invoice and get paid. Although there may be time delays between when the costs are paid for and when the invoice money is received, these time delays are usually a matter of a couple of months.
To be clear on your profit and cash flow position, take the time to prepare a budget projection of your profit and loss and then prepare the cash flow projection including all the other loan payments and other capital costs and make sure that you have both a profit and positive cash flow.