As a business owner, it’s probably no secret that one of your main goals is to make a profit. After all, if you make a profit, then you put your business in a position where it can continue operating. And if it can do that, then you can keep satisfying your customers, supporting your community, providing an incredible service, or achieving whatever else your ultimate objective may be.
On the other hand, if you stop being profitable, then other people, such as your lenders, outside investors, vendors, and even your customers could start having a say in how you operate your business. In other words, you’ll lose some of your autonomy and the ability to run your business the way you want to.
With that said, though, as important as it is to make a profit, this cannot be your only goal. You see, the reason for this is because profit is not the same as having cash in your bank account. And when it comes to staying in business, you need both.
“But why is profit not the same as cash coming in?” you wonder. Well, there are three basic reasons:
- Revenue is booked at the time of sale
- Expenses are matched with revenue
- Capital expenditures don’t reduce profit
Let’s take a closer look at each of these.
Revenue is Booked at the Time of Sale
To begin with, revenue is also known as sales. And a sale is recorded when your product or service is delivered to the customer. Then, at that point, you could reasonably record a profit after deducting the costs and expenses that are directly and indirectly related to making your product or delivering your service.
But, if it’s common for your customers to have 30 days, or even more, to pay the bills that you send to them, then you may not have actually received any cash yet. You see, since profit begins with revenue, it could merely reflect your customer’s promise to pay.
Expenses are Matched with Revenue
The revenue number is also located at the top of an income statement. And the purpose of the income statement is to add up all of the costs and expenses that are related to bringing in revenue in a certain time period.
However, those expenses may not have actually been paid during that same period. For instance, if you’re a start-up company, you may have to pay a year’s worth of rent in advance as a result of being a poor credit risk. So, some expenses may have been paid in an earlier time period.
More often, though, your expenses will be paid later, when your suppliers’ bills are due. You see, just as your customers may have 30 days to pay your invoices, you, as a customer of your suppliers, also usually have 30 days or so to pay your bills. So, the expenses on the income statement may not reveal the actual amount of cash that has gone out of your bank account during that time period.
Capital Expenditures Don’t Reduce Profit
A capital expenditure is the purchase of an asset that’s considered a long-term investment. And because of that, it doesn’t show up on the income statement when it takes place. Instead, only the related depreciation amount is deducted from revenue.
In other words, the depreciation expense will only appear on the income statement little by little, over the useful life of the asset. On the other hand, cash may have been used to pay for the asset long before it’s been fully depreciated.
Okay. Now that we’ve looked at the reasons why profit isn’t the same as cash, we can illustrate these points even further with the following example.
Let’s say you own a bakery that supplies cookies, cakes, and pies to large grocery stores. You launched on January 1 with $9,000 cash in the bank, and you’ve already received orders for the first three months. Let’s also suppose that the cost of your goods is 70 percent of your sales, your monthly operating expenses are $9,000, and the depreciation amount for the equipment that you use to bake your goods is spread out at a cost of $1,000 per month.
With that said, your simplified income statements for the first three months will look like this:
Income Statements
| January | February | March | |
| Revenue | $20,000 | $30,000 | $45,000 |
| Cost of goods sold | 14,000 | 21,000 | 31,500 |
| Gross profit | 6,000 | 9,000 | 13,500 |
| Expenses | 9,000 | 9,000 | 9,000 |
| Depreciation | 1,000 | 1,000 | 1,000 |
| Net profit | ($4,000) | ($1,000) | $3,500 |
As you can see, it doesn’t take very long for you to start growing. And, you begin making a profit in your third month. However, having actual cash in your bank account is a much different matter.
You see, suppose you have an agreement with your vendors to pay for your ingredients and supplies in 30 days. But on the other hand, the customers that you sell to are the big grocery stores. So, they take longer to pay because they can afford to pay their bills slowly.
As a result, then, they’ve set the payment terms so that they pay your bills in 60 days. In that case, this is what your cash situation looks like:
Your Cash Situation by Month
In January, you don’t collect any money from your customers. All you have is $20,000 worth of receivables from your sales. On the flip side, one piece of good news is that you don’t have to pay anything out for the cost of your ingredients and supplies, since your vendors are willing to be paid in 30 days.
However, you do have to pay for your operating expenses, including rent and utilities. So, even though the depreciation expense is not actually paid out in cash because the equipment was purchased in a prior period, the entire $9,000 in cash that you started with is taken away to pay for the operating expenses. And as a result, you’re left with no cash in the bank at the end of the month.
In February, you still haven’t collected any cash from your customers, because once again, they pay their bills in 60 days. At the end of the month, you now have $50,000 in receivables (January’s $20,000 plus February’s $30,000), but you still haven’t received any cash.
However, you do need to pay for the cost of your ingredients for January ($14,000). And, you have another month’s worth of operating expenses ($9,000). But, since you have no cash in the bank, you now have a cash deficit of $23,000.
In March, you finally collect the money for your sales from January, so you have $20,000 coming in. And that leaves you just $3,000 short of your cash position at the end of February.
But, now you need to pay for the cost of February’s ingredients ($21,000) and March’s operating expenses ($9,000). So, at the end of March, you now have a cash deficit of $33,000, which is even worse than the position you were in at the end of February.
The Problems and Solutions
So, why is all of this happening?
Well, the main problem is the inconsistency between the fact that you must pay your vendors in 30 days, while needing to wait for 60 days to receive payment from your customers. And, as long as your sales are increasing, or even if they just stay constant, you’ll never be able to catch up and dig yourself out of the cash deficit unless you find new sources of cash.
Now, as simplified as this example may be, this is exactly how profitable businesses eventually fail. They simply run out of cash.
So, if your company is both profitable yet short on cash at the same time, then you need to obtain additional sources of cash . And to do that using traditional methods, you could either borrow money from a bank by receiving proceeds from a loan, or receive capital from investors by issuing shares of stock in your company.
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