For small business owners, achieving profitability is often one of the main goals for operating the business. However, no matter how creative your business or products are your business may still struggle, and inevitably fail, if you can’t manage your company’s cash flow.
Cash flow 101: Why you should worry about cash flow instead of profit
As a reference, one study found that 82% of businesses fail due to poor cash flow management.. Especially If you are a new SME (where cash management is especially challenging), it should be a key area of focus as you get your business up and running. Before we get too ahead of ourselves, let’s first explain the difference between cash flow and profit.
What is the difference between cash flow and profit?
Cash flow is a measurement of the actual money coming into and going out of your business. The simplest method of measuring your cash flow is through your bank account — simply put, your business will have positive cash flow if there is more in the account at the end of the period than when the period began (and vice versa). Some common sources of cash flow in come from sales and investments and cash flow out comes from cost of goods, salary and interest payment etc.
On the other hand, the measurement of profit is more of an accounting concept and while it may be useful on paper (and in audited financial statements), it may not provide the necessary detailed insights into how a company is doing on a day to day basis.
Let’s walk through a couple of examples.
For example, you have a suit business in Hong Kong and last month, you sold $200K HKD in suits and the suits cost you $80K HKD wholesale, your gross profit would be $120K HKD
The first step to calculating profit is to take your total revenue and then subtract the cost of the goods sold. The difference is your gross profit.
- Revenue: $200,000 HKD
- Cost of Goods Sold: -$80,000 HKD
- Gross Profit: $120,000 HKD
Let’s say you also spent $20K HKD in marketing to achieve this level of revenue. Marketing expense would be considered operating expenses (along with things like rent, equipment purchases, payroll, etc.) are taken out of Gross Profit to get to Net Profit.
• Revenue: $200,000 HKD
• Cost of Goods Sold: -$80,000 HKD
• Gross Profit: $120,000 HKD
• Operating Expenses: -$20,000 HKD
• Net Profit: $100,000 HKD
Congrats! You now have $100K HKD in profit on your income statement.
While this profit calculation seems simple enough, there are a few areas missing when it comes to understanding the health of your business.
1. Late or delinquent payments
Once you have made the sale, this $200K HKD is registered as revenue and included on your income statement. However, most companies do not receive the full payment amount immediately. For example, if your customer decides to send $50K HKD / month for 4 month, you’ll only be able to use $50K HKD / month for all of the other expenses that you need to pay. We also haven’t thought about worst case scenarios like what if the customer goes out of business after a couple of months and you cannot actually receive the full amount for the orders?
2. Pay loan back
If you had borrowed some initial capital to start your suit business, your income statement will not show the principal repayment of these loans.
3. Paying Inventory
If you spend more funds on buying additional inventory (ie. suits) from your wholesaler, you will probably have to pay it up front and not realize sales until some time later.
While you may have a positive net profit, this is before taxes which will unfortunately decrease these earnings even further.
Cash flow is all about timing — just because you’re profitable, there are usually other expenses that do not appear on your income statement and will affect your business.
Have a look to our article “Cash is Still King : How Startup can manage and improve their cashflow”
Why is managing cash flow important?
1. Make your business more predictable
Seasonality is a often common part of running a business. Sales at ski resorts are higher during the winter and dumpling shops are more popular during Chinese New Year. A good cash flow management process will allow you to predict these cycles and come up with a plan to address them. A couple of examples:
- Provide discounts for customers that pay earlier. This way you would be able to collect and use cash faster!
- Run a marketing campaign to drive additional sales quickly
- Apply for business loans through a bank or find alternative lending sources
- Delay your cash outflow by using your credit card (you can also use Reap for expenses that do not accept cards)
2. Understand when you can grow
Good cash flow management allows you to better understand when you can use more funds towards growth. If you have made in $100K HKD in sales, but actual payment won’t be made until 3 months later, you may not funds to buy better equipment just yet. When you look at your cash flow over weeks and months, you’ll know how much to keep on hand, and how much you can stash away or spend on growth.
Obsessing over cash flow is an important consideration regardless of the size of your business. In the long run, it may also improve your relationship with your customers and suppliers if you can more accurately assess your cash flow to your requirement for paying and receiving payments.
Hopefully, it’ll bring more peace of mind to your day to day operations and alleviate some stress!