CASH is always a fascinating business subject. Here is an article that cuts to the core of cash management, written Laurie Owen when she worked for our friends at Profit Mastery…
by Laurie Owen
Do you remember high school geometry and all those conditional statements? The “if then, then therefore,” logic strings? I bet you thought that you’d never use them again. You thought wrong! Here’s one for you:
If sales do not necessarily equal profits, at least not in direct proportion, and if profit does not necessarily equal cash, therefore more sales do not necessarily equal more cash.
That doesn’t sound very logical, does it? But each of these statements is especially true for a business that has a seasonal sales pattern, lots of inventory, and carries accounts receivable.
Sales and Profits?
I think we’d all agree that in any business, there has to be some relationship between Sales and Net Profit, because to earn a profit, what do you first have to have? A sale! Generally, in most businesses as sales go up, profits go up; sales go down, profit goes down. It’s a direct, but not proportionately direct relationship. Profits don’t necessarily rise and fall in the same proportion as sales. For example, if you end up spending a lot of money on advertising and staff to drive higher sales, those added expenses can cut into your profits.
Profit and Cash Flow?
For many business models, profit and cash are typically two different things. Profit is something you make on a piece of paper (your Profit and Loss statement or P&L); cash flow is what you have on your Balance Sheet. We measure profit on the P&L by matching the expenses incurred to the sales the expenses helped produce—using the accrual method of accounting. But the P&L tells us very little about cash flow. We measure cash on a Cash Flow worksheet, using the cash basis of accounting — which tells us very little about Profit.
Sales and Cash?
Because of seasonal sales patterns in some businesses, there can actually be an inverse relationship between sale and cash: as sales go up, cash goes down; as sales go down, cash goes up. Here’s why:
In your typical jewelry store, as your sales go up, you’re buying ever increasing amounts of inventory to support rising sales, and in some cases, creating ever increasing accounts receivable. At just about any point in time, as sales rise, you are investing cash into new assets (inventory and A/R) at a greater rate than you’re collecting cash from prior or current sales.
Cash is going out faster than it’s coming in, causing a financial gap (the difference between the cash you’ve got, and the cash you need) to occur, which leads to increasing needs for short term debt to fill the gaps.
As sales go down, you are collecting cash from prior credit sales and current cash sales at a greater rate than you’re reinvesting cash back into new inventory and A/R. Cash now is coming in faster than it’s going out, resulting in cash surpluses, which allows you to repay short term debt.
This is a classic example of a seasonal business. The company’s sales are causing cash to either rise or fall depending on which direction sales are going.
To further illustrate this point, can a company have:
Positive Profit and Negative Cash? Yes
Negative Profit and Positive Cash? Yes
Negative Profit and Negative Cash? Yes
Positive Profit and Positive Cash? Yeah – and what a great thing that is!
If you’d like your business in the last category, watch your cash, manage more efficiently, and set up credit lines before you need them to handle seasonal cash needs. Invest some time creating a Profit Plan (projected P&L) and a Cash Budget (projected cash flow) so you can measure and predict cash flow and profits. What gets measured tends to get managed better. Sounds logical enough, doesn’t it?