By Ruth King.
I received this question from a client:
Lets say you have a loan you are repaying. $10,000 total – $9,000 to principal and $1,000 to interest. The only thing that shows on your P&L is the interest. The principal is reduced on the balance sheet. But if you managing the company off the P&L you are going to be light $9,000 so it’s not really an accurate picture. What’s going on?
Many of you probably have the same question. You manage profitability from the profit and loss statement. You manage cash and cash flow from the balance sheet.
Each month your profit and loss statement tells you whether you earned a profit or had a loss. It does not tell you how much cash you have. You must turn your profits into cash by collecting your receivables and paying the expenses incurred to produce those revenues.
Unfortunately you can be profitable and go bankrupt. How?
A customer doesn’t pay you for your profitable work.
You grow profitably so quickly that you run out of cash.
You are drawn into a lawsuit (through no fault of your own) for profitable and correct work that you performed or someone getting hurt on a project.
Profitability does not ensure business survival. Many businesses have a month or two months that are not profitable. Others have an unprofitable quarter and work the rest of the year to make up the losses. What they aren’t realizing, is that they are also working the rest of the year to generate the cash they need to survive that quarter the following year.
So what do you do? First be profitable. Without profits you won’t generate the cash you need to survive and thrive.
Second, determine your cash needs each month. Calculate this by looking at sales, collections, the costs to produce goods and services, and overhead costs.
Sales count. However, collections on those sales count more. If you collect COD then the sales for the month should equal the collections for the month. However, many collections are 30 to 60 and sometimes 90 days after the work was completed. You might have a sale in January, produce and deliver the work in February, and not get paid until March.
You sell a $30,000 project in January. Let’s take a look at the cash needs for February. Since you have no cash received for this job, your collections are zero.
Determine when you must pay for the cost of producing your products and services. For example, many times you’ll have to pay payroll expenses for production before you get paid for the goods and services. You may also have to pay your material suppliers or subcontractors before you get paid for your work.
In this case assume that your payroll and production costs are $5,000. They are all due in February.
Finally, determine your monthly overhead costs. These are generally the same each month and must be paid whether you sell or collect.
In this case, assume that your monthly overhead is $10,000.
For this example, you’ll need to fund $15,000 to produce the $30,000 sale that you get paid for in March.
Smart business owners manage both profitability and cash. You need both for a successful business.
Ruth King is known globally as the “Profitability Master,” and is a a thought leader in entrepreneurship and business. Her books have been recognized as among the greatest in numerous industries. Learn more about all her business activities here.