Why Higher Profits Can Lead to Lower Cash
Sara was the small business owner of a fitness and nutrition company. She had slowly grown her business over the past two years and built a loyal client base. Sara considered herself a successful entrepreneur but needed clarification when reviewing her financial statements. Why was her bank balance so much lower than her profits?
Panic was beginning to creep in as she wondered where the cash went. Her client base had steadily increased, driving profits up consistently over the past two years. Just as Sara started to feel her efforts were paying off, the cash in the bank was getting lower. Why wasn’t she seeing a healthier cash balance in her bank?
Sara needed to understand what was happening. Her accountant did the monthly bookkeeping virtually. But Sara felt her concerns warranted an in-person meeting and contacted her accountant. Luckily, her accountant was available to meet the next day.
How Does Higher Profit Lead to Lower Cash?
Sara’s accountant explained that profit is simply her revenue minus her expenses. Confusion occurs when cash is used for items that aren’t expenses on her P&L statement. Her accountant then went on to talk about five areas of cash flow that must be managed while growing a business.
Equipment Purchases
As most small businesses grow, equipment has to be purchased. Equipment purchases are usually considered assets to the company and capitalized. This means the equipment cost is listed on the balance sheet as an item the business owns. The equipment is depreciated over time, usually over five years or longer. The depreciation expense is the part that will be deducted as an expense.
Sara had purchased some treadmills for the fitness side of her business before year-end. Her accountant noted on her balance sheet that these items were shown as equipment under her assets. She then pointed to the depreciation expense on the P&L statement, which was a much lower figure. Sara had spent $10,000 on the equipment, but the monthly depreciation expense will only total $2,000 per year for five years.
Equipment purchases can usually be financed through a loan or lease. If the interest rate and down payment are reasonable, financing can be a good alternative to spending a large amount of money.
Inventory
For the nutrition side of her business, Sara began selling supplements. This area of her small business was growing, and she had been maintaining a large inventory level to keep clients interested as they came in for their weekly sessions.
Inventory is another item her accountant mentioned that stays on her balance sheet. The items she sells won’t show up as an expense on her P&L until it is sold. Sara had recently increased the inventory levels for her supplements, but sales had not yet increased.
Sara’s accountant suggested keeping a minimum amount of supplements in stock. It takes less than a week for Sara to replenish any items that she sells. Keeping a minimum amount of inventory will not use as much of Sara’s cash and will reduce the time between purchasing and selling the inventory.
Higher Accounts Receivable
Increasing accounts receivables can be an issue for small businesses trying to grow. Clients or customers are invoiced for goods or services they have received, but they do not pay for them fifteen to thirty days later.
Some of Sara’s clients were not paying as quickly as before Christmas. Sara had not brought this to their attention, she fully expected her clients to begin paying more regularly once the Christmas season had ended.
Sara’s accountant pointed out that every time she invoiced a client, it showed up as revenue on her P&L, but receiving the cash for those invoices was taking longer than usual. She suggested implementing new payment terms for her clients to keep her cash flow in line with the monthly revenues she was billing.
Lower Accounts Payable
Sara prided herself on always paying her bills as soon as she received them from her vendors. The accounts payable balance on her balance sheet was lower now than a few months ago at year-end.
While Sara’s accountant admired her desire to pay her bills quickly, she noted since client payments had slowed down, she was putting herself in a difficult situation by paying her vendors earlier than required.
Paying bills on time does not require that they are paid early. Unless the vendor offers a discount for paying earlier than the due date, keep your cash until the bill is due. A good rule of thumb is keeping accounts receivable and accounts payable low. If the balance of receivables and payables is low, that means your clients are paying timely, and you can pay your bills timely.
Loan Payments
Sara started her fitness and nutrition business with a small SBA loan two years ago. Eager to pay the loan off as quickly as possible, Sara had finally made the last payment during the past month.
It’s typically a good plan to pay down loans as soon as your cash flow allows, however doing so can hinder building up a healthy cash balance. Sara’s accountant showed her how paying the loan off had decreased the liabilities for her business. But this is another item that doesn’t show up on the P&L statement as an expense. Only the interest expense for the loan is deducted from revenues while paying down the principal reduces the loan on the balance sheet.
With the loan paid in full, Sara should start seeing the additional cash flow available that was being spent every month on her loan payments.
Always Maintain a Cash Flow Forecast
Now that Sara understood how her spending was shown on her financial statements, she felt more confident about managing her cash. Her accountant suggested keeping a cash flow forecast projected several months ahead. Forecasting cash flow will help maintain a comfortable bank balance and help highlight any potential issues.
Follow Sara’s example and take control of managing the cash your small business generates. Alleviate stress by knowing your business has the money necessary not just to survive but grow and prosper the way you envisioned from the start! Budget your cash flow and take better control of the future of your small business.