Cash generated and profits earned will nearly always be two different numbers. Only in the smallest and simplest of businesses will they be the same. You can blame us Accountants for this variance but in our defence there is good reason for how certain items are accounted for.
Pure cash generation is the difference between the money received and the money paid out by the business over a period. There can be several reasons as to why your profits will differ from cash generated and to understand these reasons is critical, especially as your business grows. The only reason that a business will fail is due to its inability to pay its debts and so profits do not guarantee survival.
Some reasons for the mystery around negative cashflow would be:
1. Investing in Stock
As a business grows a business owner will make the decision to increase the holding of stock he or she has to sell. This is especially true in retail and wholesale businesses and the control you have over the extent of this stock holding is key. Get it wrong and you will be “overstocked” which results in too much of your cash tied up in stock.
You can sell all you want but if you don’t get paid you won’t have the cash! If the credit terms that you offer your customers are too long it will put your business cash resources under pressure and reduce your ability to reinvest. In addition, it may not be that you have given extended credit terms but some of your customers have decided to take extended credit terms! Managing your debtor and credit control is key regardless of your business size. We will have a future blog post on tips to assist with managing your debtor cycle.
3. Loan Repayments
Capital Loan repayments are made from after tax profits. If your business loans are structured incorrectly it could result in your business (even if profitable) having insufficient resources to meet repayments. It is therefore essential when setting up your loan arrangements that the term of the borrowing is appropriate for the type of borrowing. i.e. a borrowing to fund the advance purchase of stock for a season would have shorter repayment terms than a loan to fund the extension of your business premises.
4. Asset Investments
As your business is growing you are likely to invest in capital, equipment or other long term assets to help with growth. These investments are not costs that would be recognised in your profit & loss account and so your business will be using the cash generated from profits to fund these acquisitions. That is why it is extremely important as your business grows to have a plan in place as to how you are going to fund that growth. Be sure to have a look at the other blogs that we have done on funding options for your business growth.
5. Prepaying of Expenses or Certain costs
Paying for certain costs in advance (insurance, annual rental etc.) will result in a variance between profits and cash. These types of costs would be expensed over the life of the agreement (e.g. annually) but the cash would all have been spent up front.
Managing cashflow is a major challenge for all businesses but especially those that are growing and expanding. Having a plan in place will help achieve the overall goals and also help with sleep and stress levels while you are on the journey!
If you would like to put together a growth plan and manage your cash resources to achieve this plan why not give one of the team a call. Helping businesses grow is what we love doing!