There’s a problem I see over and over again with business owners like you. Too often I see businesses that appear to be doing well and one day they close their doors and disappear from the world. This is something you likely don’t want to have happen in your business.
There is one simple reason why this happens. That reason is the topic of this week’s video and it’s one that if you don’t learn could lead to really unhappy experiences in your life.
You might be asking yourself, what is it that I’m talking about? It’s really very simple. You need and I mean need to understand the difference between profit and cash flow. You might think you have this nailed. The unfortunate thing I keep seeing over and over is there are few businesses and owners who do have it nailed.
There’s a problem I see over and over again with businesses. Too often I see companies that appear to be doing well and one day they close their doors and disappear from the world. I bet this is something you don’t want to have happen to your business.
Now there’s one simple reason why this happens. That reason is the topic of this week’s video and it’s one that if you don’t learn could lead to really an unhappy outcome for you.
You might be asking yourself, what is it that I’m talking about? It’s really very simple. You need and I mean you need to understand the difference between profit and cash flow. You might think you have this nailed. The unfortunate thing I keep seeing over and over and over is there are few businesses and even fewer business owners who understand the difference between profit and cashflow.
So let’s jump right in and take a look at this.
You know, here’s something I want you to understand first. Profit and cash flow are two very, very different things.
Profit is primarily a measurement the government uses to figure out how much you owe in taxes. And it’s been put together by account so look at the history of your company it shows nothing that’s really useful about what’s going to happen in the future or how much cash you have to run your business in the future. It does show you if you made a profit or not. Now a profit is a component of the cashflow but it’s not the whole thing.
Cash is what you run your business with. Profit is not what you run your business with. So you really need to understand that cash is way more important than profit and cashflow is what helps you create cash.
A cash flow statement will tell you how much cash you have, where it came from, and where it went. It’s much more important than your profit and loss statement because frankly if you don’t understand where your cash comes from and where cash goes, it’s really easy to be profitable and still run out of cash. In fact, it happened to me three times.
Here are some myths about your profit and loss statement.
It doesn’t tell you if you’re creating or using cash. Now most people say “well I know I understand my P and L, “I know if I have cash or not”. Well, it’s a component, it’s one thing about it but it’s not the whole deal.
It doesn’t take into account all the ways you spend money.
Most of the time, you aren’t matching sales and costs in an appropriate manner. That’s because you’re looking at your profit and loss statement, you’re not looking at the inflows and outflows in cash.
And the truth is, if you’re doing your profit and loss statement correctly, you’re doing it on what’s accrual based accounting which means you recognize a sale when it happens and you recognize an expense when it happens. Well the difference with cash accounting is you recognize the cash when it comes in and you recognize the cash when the cash goes out. Now again, if you’re using cash accounting that’s probably a different way to look at cash flow, it doesn’t tell you the whole story.
The things that eat cash aren’t even on your profit and loss statements. It’s the same thing that might create cash also.
- Receivables, if they increase you’re eating cash and you’re playing the bank.
- Inventory: if it increases, you need to be buying more material and that costs your money. Now the opposite of it goes if you’re reducing your inventory or you’re reducing your receivables, that means you’re creating cash.
- Equipment: If you buy equipment through cash it doesn’t show up in your profit and loss statement, except for a small part that’s called depreciation. But when you buy equipment, you have to use cash to pay for it. Does it come from your bank or does it come from your bank account or are you getting credit for it?
- Another thing that doesn’t show up in your profit and loss statement is principle payments on loans. When you pay a loan back it doesn’t show up as an expense on your profit and loss statement but it does show up as a use of cash on your cashflow statement.
- Now finally, life insurance premiums you pay for principles in your company do not show up on your profit and loss statement but they do show up on your cashflow statement because they go out. Life insurance is not a pretax expense, it’s an after tax expense.
So here are three ways you can create cash you won’t see on your profit and loss statement.
- When you reduce your receivables you’re creating cash.
- When you reduce your inventory you’re creating cash.
- When you borrow money from the bank you’re creating cash.
So here’s what a cash flow statement does and a profit and loss statement doesn’t do.
You see where all your cash is created. Profits, changes in inventory and receivables, borrowing from the bank. You actually get to see where your cash went. You add cash created to cash used and you now have your cash flow.
In other words you take all the cash you created and you subtract all the cash that you used and now you have your cashflow. That helps you tell you where the cash is in your business.
Remember, you run your business on cash and not on profits. If you ignore this you do so at your peril and frankly I would rather have you stay in business than go out of business by mistake.
Now that you know the difference between profit and cash flow what are you going to do about it? Why don’t you let me know in the comments below.
While you’re at it, why don’t you DOWNLOAD our Free eBook on Simplified Budgeting. You just might find a budgeting system that’s easy to use and will actually look at people in your company.
Hey this is Josh Patrick. You’re at the sustainable business. Thanks a lot for stopping by. I hope to see you back here really soon.