Have you heard the expression, "revenue is vanity, profit is sanity, but cash is king"? Accountants use this phrase all the time, but let's take a deep dive into what it actually means.
What does this actually mean?
Well, if a business owner says – “we turned over $500k last month” – then they are talking about revenue (i.e. sales).
Last month, the business’s sales were $500k. But this revenue figure only represents the top line or vanity. Maybe the business’ expenses are $600k per month, or maybe nobody has paid their invoices for these sales – so the business doesn’t have any cash.
There are two types of profit – gross profit and net profit. If the business’ sales were $500k for the month, and it cost the business $250k to produce their product or service (these are direct costs, i.e materials or labour) then the gross profit would be $250k and the gross profit margin would be 50%.
In this case, profit is sanity, because the business knows that it’s selling a profitable product or service. Whether 50% was a good profit margin, this would have to be benchmarked against the business’ industry.
Next up is net profit – all your operating expenses or overheads are deducted from the gross profit, which shows if your business is profitable, indirect costs such as rent, your accountant, advertising, software subscriptions, your website etc are next deducted. Continuing to use my example, if the business has $150k of overheads – their net profit is $100k. I think this business would have most of their sanity in check, as they are making a decent profit each month (depending on how hard it is to make these sales of course!!).
What I have described to you above, is a concept most business owners would be familiar with, the profit and loss statement (P&L). Revenue – all expenses = profit.
The next step, is where things start to unravel and where even the most profitable of businesses get into trouble. Cashflow. Why is cash king? Because if you don’t have any cash in the business, it’s very difficult to meet all of your obligations.
How does a profitable business not have any cash in the business?
Well, assuming that the business has been able to collect the full $100k from it’s customer’s each month. It then uses the cash to pay for financing obligations; repayments of loans to the bank which were used to open the business and repayments of vehicle loans. It also decides to purchase a new piece of technology that will help it’s operators and lastly, the director is a bit disorganized in their own life, and in addition to their PAYE salary they take, they also draw money from the business(drawings).
All of this adds up to $50k per month. Leaving $50k equity in the business. Which is good, because this cash will be needed to pay tax bills and dividends come year end.
Meet, the Queen; The Balance Sheet
What I have described to you above, is another financial statement, business owners overlook, and I would argue, is more important than the P&L and that’s the balance sheet. The balance sheet will tell you, at any given time, if you can meet the business’s obligations and if not, where your Mr King, cash is going.
Cash is king, because this business has enough cash to meet it’s obligations.
Let’s look at the example again, but with a worse outcome. The business is always behind on it’s invoicing, and they don’t do a good job of debt collection, they don’t save for GST or PAYE and they don’t have a cashflow forecast in place. Basically they are not really sure where their cash is going. There’s very little equity in the business, because the business wasn’t able to collect all the cash from the revenue in the first place and they have outstanding tax bills to pay. They don’t have enough cash in the business to meet all their obligations, even though they have a profitable business.
And if you don't have a profitable business in the first place (remember, this business had a 50% gross profit margin), then, well, things are looking pretty dire!
How to break the cycle
Like any good cycle, it's a vicious one and it's difficult to break free from. However, we are your get out of jail card. Having the right people supporting your business to manage your cash is crucial for the success of your business. If you want to end up like example A, give us a call.
Comments