“I don’t get it. My accountant tells me I am profitable, and yet I keep losing cash.”
“We’re out of cash? Why did my accountants not see this coming? Now I am going to have to call all my vendors to let them know we can’t pay them this month.”
“Why can’t anyone tell me if I can afford to pay my employees bonuses this year?”
Any of this sound familiar? Cash flow seems like a concept that should be so simple to manage, and yet it is often done horribly, even by accountants, and is the source of one of the biggest frustrations for a business owner. Accountants and bookkeepers are typically hired to put together monthly financials. This is an exercise of looking backwards, categorizing transactions in previous months. They typically are not looking forward unless they are specifically engaged to do budgeting and forecasting.
It is important for small business owners to realize that cash flow issues happen far more frequently than anyone thinks, and they should not feel ashamed for mishaps. I have spoken to many business owners who have had to ask they their staff to patiently wait an extra month for their payroll cheques, go on payment plans with CRA for not remitting taxes on time, and run out of cash even during very profitable months and not see it coming.
The most common misconception is using the profit and loss statement as a gauge for operational cash flow. “My income statement tells me I am making $20,000 per month, so I should be seeing my bank increase by $20,000 per month, right?” Not necessarily.
The answers to these questions typically lie in the balance sheet. Most entrepreneurs know their top line revenue, gross margins, and some may even know their net profitability. However, most entrepreneurs I meet do not know anything about their balance sheet and don’t understand its importance. Cash flow is driven not only by your monthly revenue and expenses in your profit and loss statement, but also by assets, debt and equity components in your balance sheet. I will jump into some of the most common examples.
The most common forgotten element of the balance sheet, which impacts cash flow is the repayment of debt. If you are catching up on overdue payables, this will not be reflected in the profit and loss statement, even though you are writing a cheque for a substantial sum. For example, if you are behind on three months (January to March) of legal bills for $5,000 a month, and you write a cheque in March for $15,000 to catch up on all overdue payments, your profit and loss statement will only reflect a $5,000 legal expense for March but your cash outflow is $15,000. This creates a discrepancy of $10,000 between your profit and loss statement and your cash flow.
Another common element is deferring collection of revenue. Perhaps in certain circumstances, you provide extended payment terms to clients and allow them to pay later. We will use the example of a $20,000 sale, where the customer is granted 60 days to pay. If the sale occurred in January, then you will have $20,000 of revenue in January, boosting the profit and loss statement and thus boosting net profit. However, in reality, the cash does not hit the account until March. Therefore, relying on the profit and loss statement in January to gauge cash flow is problematic.
There are many other balance sheet transactions that can cause a disparity between the profit and loss statement and cash flow including purchasing equipment or furniture, paying out a shareholder, deferring payment to vendors, draws on the line of credit, and intercompany transactions or transferring cash from one business account to another.
At an early stage, managing cash flow is often one of the most stressful activities borne by a business owner. It is a complicated exercise, requiring forecasting and planning. Unfortunately, when it comes to day to day operations, it is just as important as understanding if you are profitable. We feel it is prudent to budget cash flow six months ahead, have a plan for capital expenditures and manage the balance sheet on a monthly basis. Taking a little extra time and effort to get this right will prevent the massive headaches that can come in the future when you begin to wonder how to keep the lights on.
