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While we are trained to think of business as sales minus costs and expenses, which is profits, we have to manage cash as well.

Although cash is critical, people think in profits instead of cash. We all do. When you imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be. We are trained to think of business as sales minus costs and expenses, which is profits. Unfortunately, we don’t spend the profits in a business. We spend cash. Profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health. Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash, as well as profits.

A simple example
One of the best ways to understand the dilemma of cash vs. profits is to follow an otherwise-profitable company going broke because it can’t meet its obligations. This is a quick and simple example. It also leads us into the relationship between income statement, balance sheet, and cash.

Start with \$100, which we’ll call capital. At the beginning of this exercise, your balance sheet has assets of \$100—the money—and capital of \$100. Assets are equal to capital plus liabilities. A summary of the simple financial statement at this point is shown in this first illustration, Starting Numbers.

Starting numbers

If you buy a widget for \$100 and sell it for \$150, you should end up with \$50 profit, which is what your income statement covers. Sales minus costs are profit. You should have \$150 in the bank. Now your balance sheet shows the same \$100 in original capital plus \$50 in earnings, which are equal to the \$150 you have in cash as an asset. The next illustration shows you how the financials work after the sale.

Sell a widget

Buy another widget for \$100 and sell it again for \$150, and now you have \$200 in the bank. Do it again, you have \$250 in the bank. Your income statement shows sales of \$450, cost of sales of \$300, and profit of \$150. The illustration shows your income statement and balance sheet at this point.

Sell three widgets

Now go back a step and make the situation more realistic. For example, most sales of products to businesses go on terms, with the money due in 30 days. So if you sold that widget on credit you don’t have \$150 in the bank. You still have \$50 in your bottom line, but now you have nothing in the bank. Instead, a customer owes you \$150, which is what we call “Accounts Receivable.” Compare the Sell a Widget illustration to this next illustration, Selling on Terms. This is what really happens to the huge number of businesses that sell to other businesses.

Selling on terms

Knowing you can buy a widget for \$100 and sell it for \$150, you get your Widget supplier to sell to you on the same terms you sell, net 30, instead of for cash. Now you have \$100 that you owe to suppliers, which is called “Accounts Payable.” You also have \$100 worth of widget in inventory. This gives you the case in the following illustration, Buying on Terms, in which you are now poised to sell another widget and make more profit.

You have an extra \$100 in assets (the widget in inventory) and an extra \$100 as liabilities (Accounts Payable), so you are still in balance. Also, you still have no money. Our next illustration shows the financial picture with sales to businesses on credit and purchase of inventory on credit as a short-term debt.

Numbers mount up

Now the case is more like what you have with real business numbers, in which you have to manage your cash very carefully, and the amounts sitting in inventory and accounts receivable are significant.

More realism: working capital
Even in the case of the above illustration, the example is completely unrealistic. Where are the running expenses, such as rent, salaries, telephones, or even advertising those widgets? How would they affect the cash situation? How far would we get if we couldn’t pay the rent or the telephone bill while waiting for customers to pay us? Furthermore, what supplier would give us a widget on credit when we have no history and no assets? What bank would loan us money in this situation? Banks do loan against inventory and receivables, but only to a certain percentage of total value. What was missing here, all along, was working capital.

Important: In strict accounting terms, working capital is equal to short-term assets minus short-term liabilities. In real terms, however, working capital is the glue that holds your cash flow together. Get it into the bank before you need it, or you won’t survive the unexpected.

The following illustration goes back to the beginning of this whole example and does it right, with enough capital in the beginning to finance the company.

Working capital

Instead of starting with \$100 as capital, this business looks a lot better with starting capital of \$400. With this additional capital from the start, buying on credit and borrowing against assets is more realistic. In this scenario, working capital is up to \$550. Now it has a proper input of working capital at the beginning. With even the barest of business plans, we could tell that \$100 wasn’t enough to get this business going.

I hope the theoretical examples help make the concepts clear. If you followed these illustrations, you can see some enormous implications for running a business.

Important: Every dollar in accounts receivable means a dollar less in cash. Every dollar of inventory is a dollar less in cash. Every dollar of accounts payable is a dollar more in cash.

Continue reading The Difference Between Cash and Profits: Part 2

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Tim Berry is the founder of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry. More »

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