I learned how to manage cash flow first in business school, in a classroom setting, but it didn’t really mean anything to me until years later, as I was building my own business. Once my sales and profits skyrocketed, my cash flow dropped. It was all theoretical until I found myself in danger of going under and missing payroll, while at the same time the business was booming.

I’ve seen in the decades since then that a lot of us fall into the same trap that caught me: We think in profits, but we spend cash. Our culture encourages us to think that way; it’s built in. The classic business plan on a napkin is about selling something for a lot more than it costs you to build it. In the long term, that should be enough. But it isn’t always.

So, the moral of this story is do as I say, not as I did. Mind your cash flow. Don’t confuse profits with cash. I did manage to crawl out of the temporary cash flow problem, but it took extra mortgages and heavy credit card debt.

The point is that I wasn’t watching. The profits made me feel safe—when I wasn’t.

Profits are false prophets

The underlying problem is basic financial and accounting standards. Throughout the Western world, we live with a business practice rooted in the profit and loss statement, also called income statement. It shows the performance of the business over a specific period of time, usually a month, quarter (three months), or year.

It starts with sales at the top, then shows direct costs (also called unit costs, and costs of goods sold, or COGS) below that. It subtracts the direct costs from the sales to show gross margin.

Then it lists expenses, including fixed expenses like rent and payroll and discretionary expenses like marketing and promotion expenses. Technically, interest and taxes are both expenses, but they often show up as separate from the operating expenses. And the profit, at the very bottom, is the result of subtracting the expenses (including interest and taxes) from the gross margin.

This grandfather of all accounting statements sets the tone for many business discussions. It sets our vocabulary too—we refer to “the top line” as sales and “the bottom line” as profits.

But here’s the problem: The profit and loss feels like it’s the whole health of the business, but in fact, it isn’t.

Here are some of the problems with taking this main statement as the full health of the business:

  1. Sales in the profit and loss aren’t necessarily money in the bank. Accountants record sales and add them into the Profit and Loss when the service is performed, the goods delivered, or the ownership changes hands. The accounting in Profit and Loss doesn’t care whether we actually have the money or not. If we sell for cash, credit card, or check, then we probably do; but if we sell on account, as most businesses do when they sell to other businesses, then we don’t have the money. Instead of money in the bank we have money owned to us, which we call Accounts Receivable.
  2. What shows up as costs and expenses in the profit and loss aren’t necessarily the whole picture. A product business buys or builds its stuff to sell in advance of selling it. So it pays for it, often enough, in advance of selling it. But it doesn’t show up in Profit and Loss until the month it sells. Money spent on inventory doesn’t show up in Profit and Loss until the sale.
  3. There are other mismatches between spending and profit and loss. Depreciation, for example, is an expense that subtracts from profits but doesn’t cost you money. And if you put off paying your business bills, then some of the costs and expenses that show up in Profit and Loss are not spent yet.

You have other spending that the Profit and Loss Statement ignores

There are several kinds of normal business spending that you won’t be able to track on the Profit and Loss. These items aren’t there because accounting standards puts them into the Balance Sheet, which tracks Assets, Liabilities, and Capital. But they still cost money.

  1. Buying assets costs money you don’t see in the Profit and Loss. What you spend to purchase inventory, purchase equipment, land, chairs, tables, desks, kitchen equipment, and so on, never shoes up in Profit and Loss. Those are assets. You account for them, yes, but they don’t affect profits.
  2. Repaying debts costs money you don’t see in Profit and Loss. The interest you pay on your business loans is an expense that reduces profits, but principal repayment isn’t. It affects the Balance Sheet only.
  3. Paying dividends, draw, or distributions doesn’t affect the Profit and Loss. Here too, this is spending that costs you money, but doesn’t affect profits.

Conclusion: Mind your cash flow

Watching profitability isn’t enough. Unless you have an extremely simple cash-only business, you need to watch cash flow. Profitable businesses go under sometimes because they run out of cash waiting for accounts receivables, or financing unused inventory, or repaying debts.

There’s good reason that proper accounting includes three main statements: Profit and Loss, Balance Sheet, and Cash Flow. Really knowing your numbers takes working with all three.

Do you have questions about how to track your cash flow?

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