Many SME owners struggle to differentiate between profit and cash flow. If asked to produce a cash flow forecast, most will revert to producing a profit forecast. But profit and cash flow are definitely not the same.
Growth is not necessarily a sign of success
For example, did you know you can actually go broke if your business grows too quickly? Your sales could be going through the roof and doubling each month. From a profit perspective, your profit and loss statement will show that you are making a lot of money. But what if:
- Your sales are on credit and customers take too long to pay?
- You need the cash to pay your suppliers in 30 days?
- 40% of your stock lines are not moving and cash is tied up in stock?
Consider the other ‘non-profit’ cash requirements
Running a business means that cash is required for infrastructure. Hopefully you are making a profit to start with and this is generating cash for the business to pay for these things. Your profit also needs to be sufficient to generate enough cash to do things like:
- Paying for various business assets or
- Helping to meet the repayments on loans to buy these assets
- Making repayments on a loan that might have been taken out to buy the business in the first place.
- To pay for income tax that is payable on prior year profits and also the current year if you are paying tax under ‘Pay as You Go’ system.
Providing for drawings to the owners if they are not taking actual salaries.
As you can see, there are a number of areas that need a supporting cash flow over and above the purchase of goods to sell for a profit.
Is your cash flow sustainable?
Sometimes businesses take advantage of credit from suppliers in order to create spare cash in the business. In the first year of business, this can produce a good uplift in cash surplus. This will be reduced where the business is also required to provide credit to its customers. In the second year, the uplift is much smaller – being only the change from one year to the next. Cash might also come from the one-off sale of a spare assets, such as a spare block of land or other such asset. Alternatively, the owners may be able to put a one-off injection into the business.
‘Sustainability’ is judged by assessing whether or not the business cash flow next year will be in surplus without these one-off injections. If the business needed a one-off injection this year – why? And once you know ‘why’, have you fixed the problem so that next year, the deficit won’t reappear. In most cases, it will flow from poor profitability. And how you might improve business profits opens a whole raft of questions that can be worked through to see how you can drive the business to perform better, such as –
- How can I increase sales?
- Are there other revenue streams the business should be looking at?
- How can margins be improved?
Can operating costs be saved? Where? How? When?
Get the true picture: ‘A thousand words’
Just as a picture is said to do, a cash flow statement can paint a thousand words about a business. We recommend that you ask your adviser for a cash flow statement each year, as well as your profit and loss statement and balance sheet, so that you can see just how sustainable and healthy your business actually is.
RSM are specialists in the SME sector, get in touch with our Team if you have any questions.