Why Profit Isn’t The Same As Good Cash Flow

If you launched a startup and found you’d made a substantial profit at the end of your first year, you’d feel you’d beaten the odds. However, if you also found you had no cash in the bank and hence no way to pay your business taxes, you would pretty soon realise that it was something of a pyrrhic victory.

In a nutshell, that’s the difference between profitability and cash flow. But how can this paradoxical situation occur? How can a company turn a profit yet have no cash at the end of the year to show for it?

Not All Transactions Are Income Or Expenses

If a company generates €50,000 a year and has expenses of €30,000 a year, it will generate a pre-tax profit of €20,000.

However, if the owner requires €30,000 a year for personal expenses and draws €2,500 a month out of the company, the business will end up €10,000 in the red at the end of the accounting period. That’s because this type of cash out will be recorded on the balance sheet rather than the profit and loss statement.

Conversely, a company can generate no profit at all whilst having a positive cash flow. If the owner injects personal cash to keep the business afloat or takes out loans for the same purpose, these transactions will again appear on the balance sheet.

What accounting basis will you use?

Whilst the actual nature of the transaction will determine whether it appears on the balance sheet or the profit and loss statement, your accounting basis will significantly affect the amount of profit you record.

If you use the accrual basis, you will record your income and expenses when they are incurred (i.e. billed). If you use the cash basis, you will record your income and expenses when they actually occur (i.e. when money changes hands).

Some business owners try to gauge profitability from their bank balance, but this can be very misleading: chances are you extend credit to your customers and use credit to finance your purchases.

When these transactions actually take place, they will have a huge impact on your finances.

Understanding Your Burn Rate

To assess the health of a new company’s cash flow, rather than its profitability, you need to know the burn rate.

In simple terms, this measures how long the money you have will last before you go into the red. If you were spending €1,000 a month on rent, €3,000 on salaries and €1,000 on bills, your gross burn rate would be €5,000 a month.

However, if you were already generating income – even whilst making a loss – your net burn rate would be reduced. Let’s say you’re selling goods worth €4,000 a month at a net cost of €2,000: your net burn rate would then be reduced to €3,000 a month.

Why Cash Flow Is King

Profit is obviously the goal of any startup, but a business that is breaking even or making a small loss can remain in business.

A company with a negative cash flow cannot do so without borrowing or without the owner injecting personal cash. Don’t forget to monitor your cash flow closely and calculate your burn rate accurately – it can be key to your survival.

___________

Sharing is caring!