Why cash is more important than profit ?
What does it take to make a success of your small business… how can you avoid adding to those frightening statistics about failure rates of small business?
So....What do you need to know about financial management and how do you need to apply that knowledge to put your business on a solid financial footing?
There are 3 principles you need to understand to manage the finances of a business well:
- Why do we need to make profit?
- Profit and cash are not the same thing at all and they don’t even have a direct relationship between each other.
- Cash is what you must worry about all the time… not profit
Let’s address the principle about profit first. The first thing to understand about profit is that it is not the purpose of business. Profit is a vital component of business, but it isn’t the reason the business exists. The purpose of your business must be something much more important and something your customers actually care about.
The 3 Functions of Profit
Profit has 3 functions:
- To pay investors and stake holders in a business a return on their investment.
- To provide the business with funds to invest in itself to grow or develop the business.
- As the thing by which we measure how well we are doing in running the business.
The first function is straight forward, if someone invests $100 or an hour’s work into a venture, that person wants to see a return for that investment. That return can only be payed out of the profits of the business.
The second function is also straight forward, in that, if you want to buy a new machine or tool or vehicle for your business you need to have the money to pay for that. Profit is what provides that money. (You can borrow for that purchase of course, but then the purchase is effectively made out of future profits)
The third function is about this: How do we know if our business is going well or not so well?
The simplest method to answer that question is to keep track of the financial numbers and profit is one of the most important of those.
Profit and Cash
The second principle about profit and cash is what brings a lot of small businesses unstuck. A large proportion of the businesses that make up the horrendous statistics on failures in small business do so because of a lack of understanding of this principle. Profit is a simple sum (on paper) of sales minus costs. So if you sell stuff in a week for a $100 and it costs you $50 in raw materials that week and $25 in office costs, it means that you have made $25 profit that week. Cash (your bank balance) bears little relation to those numbers in most cases. The $100 of stuff you have sold might not be paid for that week or even that month. You also might have had to pay for the raw materials some time previously and your office costs (staff and rent etc) may have to be paid every Friday. So that at the end of the week your bank account will actually be significantly in the red even though you’ve made a profit.
So cash needs to be calculated in a different and slightly more complicated manner than the simple profit and loss equation. When thinking about cash it is useful to think in terms of flow… money flowing in and out of your account, like a river flowing into the sea. If it rains upstream in Queensland for example, it may take a month for the Darling River to start swelling downstream in South Australia. So when talking about cash we usually talk about cash flow…. Money flowing in and money flowing out. If more money flows into your bank account in a given period than flows out in that period, your bank account swells and vice versa. Cash is the main thing And that brings us to the third principle.....
That you need to understand about financial management of the business.
I said that the thing to worry about in your business is Cash and not Profit. For most people this is a counterintuitive statement.
The truth of this principle is actually much more straight-forward than you might think, because: Only cash can be used to pay for stuff. Theoretically, your business may never make a profit and yet survive, as long as you continue to have enough cash to pay the bills, your staff, your raw materials, the rent etc. Obviously without making a profit, the business will ultimately run out of cash, but that can take years in some circumstances. So as a business owner who is committed to put his business on a solid financial footing, Cash-flow must always be your first concern!
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