The Story of Profitability and Cashflow

The Story of Profitability and Cashflow

October 11, 2023

Pretend you have 2 children.
One you named Profitability, the other you named Cashflow.
I’ll bet that too often in your years of business in the past, you have ignored Cashflow and paid too much attention to Profitability.

These 2 children are very different.
Profitability is very smart, very logical and thinks long term- the next year, 2 years, 5 years…
Cashflow however, is needier, and when he gets sick, he has a good chance of dying.  So when you ignore him, and he starts crying, and you still  ignore him, when you finally pay attention to him, its going to take a lot of work to get back to health, IF you are not already too late. Cashflow sometimes does not think as logically or as long term like profitability does, because he only cares about today, tomorrow, next week and maybe next month.

What to do?

Run your decisions by both children.
Every time you have a financial decision, ask Profitability what he would do, and ask Cashflow what he would do.
Their answers could be surprisingly different. And if you are in a Cashflow crunch, you should at least listen to Cashflow more, if not make your whole decision based on his cries.
Someone once made the statement that “profitability is what you pay taxes on, cash is what you take home.”  I wish I had said that because it’s a brilliant way to point out the differences.  And in a small business- especially during its formative years (1 month to 7 years) Cashflow performance is critical.

As a small business owner, you must manage or oversee everything that goes on within your business, including employees, inventory, and marketing and office supplies. However, unless your business has an ample cash stream, you won’t have anything to manage or oversee. After all, your employees need to be paid, your inventory needs to be purchased, your accounts receivable needs to be funded, and supplies need to be replenished. All with cash.
This lesson will explain why Cashflow is, in fact, the lifeblood of your small business. The lesson is also intended to provide you with the knowledge and tools necessary to manage your cash.

So you need toilet paper…..
The Profitability child would say “Go to the wholesale club and buy 71 rolls of toilet paper because they are only .34 per roll and way cheaper than the grocery store…” But your Cashflow child would whine “No!”  I know the grocery store price is .89 per roll but you only need 3 rolls- or $2.67 total we have to spend. Those 71 rolls at the Wholesale Club are going to cost $24.14. Please- only spend $2.67 and not wipe out what little cash we have.”

Step 1. Understanding Cashflow

Let’s begin with a definition: “Cashflow is the ebb and flow of cash in your business.”
Or, here is another one: “Cashflow is the flow of money (cash, checks, electronic debits and credits) in and out of your business.”
Cashflow is an overview of your check book, savings account and investment account. However, knowledge of those accounts won’t:

    1. Tell you where your cash is heading.
    2. Help you to arrive at any meaningful decisions.

Remember the quote in the introduction of this topic – the one about cash being “what you take home?” In the interest of emphasizing how important cash is (as opposed to profitability), let’s put that statement another way:

“If you don’t have any profitability you won’t have to pay your taxes. If you don’t have any cash, you can’t pay your bills.”
“Profitability” is an accounting term of special interest to people who collect your taxes, while “cash” is the money that resides in your cash register and in your checking, savings and investment accounts. Cashflow measures the ebb and flow of that money, the successful measurement and forecasting of which allows the small business owner to make a myriad of important decisions.

Decisions such as:

    • Do I buy a new computer or software system?

    • Do I purchase or lease that delivery van?

    • Do I hire that new salesperson?

    • Do I bring in extra inventory?

    • Can I afford to give my special customer an extra 30 days to pay his bill?

Step 2. The components that impact Cashflow

Four primary components are responsible for the ebb and flow of a small business’s Cashflow.

Those components are:

    • Profitability

    • Inventory

    • accounts receivable

    • and FF&E (furniture, fixtures and equipment)

Let’s consider each of them as they relate to cash.

Profitability: Profitability is the number that comes from the bottom line of your Profit and Loss Statement (P & L). It is the figure your accountant transfers to your tax return.
In essence, if the bottom line of your P & L is positive – if you’ve made money – then that profitability positively impacts cash. Make money, your cash increases. Lose money, your cash disappears.
But the P & L doesn’t tell the entire story, where cash is concerned. There are two reasons for this:

    1. There are line items on the P & L that affect profitability but don’t impact cash – depreciation and amortization.
    2. There are line items on the Balance Sheet that do impact cash yet aren’t part of the P & L. See the explanations below for Inventory, Accounts Receivable and FF&E.

What this means is that while profitability has a major impact on Cashflow, it is not the only contributor. Here are some others:

Inventory: The purchase of Inventory requires an outlay of cash, but that outlay does not appear on the P & L. This is because inventory is an asset, similar to cash, accounts receivable and FF&E, and only appears on your Balance Sheet.
A build-up of inventory requires an expenditure of cash. If your inventory has increased in the past month (or whatever your financial statement cycle is), then your cash has decreased by a like amount. The opposite is also true: If your inventory decreases your cash will increase.

Accounts Receivable:
 Accounts Receivable (AR) is basically cash you have loaned to your customers between the time they receive your products or services and the time they pay their bills. It takes cash to fund those receivables, which means that if the amount of your receivables has increased from one financial statement cycle to the next; your cash has decreased by a like amount.

Furniture, Fixtures and Equipment:
 Cash spent on FF&E amounts to expenditures for capital goods. Because capital goods have an extended life (as opposed to supplies, for instance, which are generally consumed within a year) they cannot be 100% expensed on your P & L. The amount that can be expensed is called “depreciation” and that amount is determined by various taxing agency regulations.

This means that if you were to purchase a capital item for $20,000 on the first day of your accounting cycle, this would have a negative effect on your cash of $20,000. However, it would only have a $5,000 negative effect on your profitability, assuming that it can be depreciated over four years. This $5,000 shows up as “Depreciation Expense” on your P & L, while

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Date February 22, 2024
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Date March 25, 2024
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Where’s My Cash Gone?