Profits aren’t cash. Profits are an accounting concept; cash is what we spend. We pay the bills and payroll with cash. While the plan-as-you-go business plan doesn’t necessarily include a full-blown financial forecast (at least not until needed) it should still be aware of cash balances and cash flow.
This should be a pretty simple concept, but it gets hard because we’re trained to think about profits more than cash. It’s the general way of the world. When they do the mythical business plan on a napkin, they think about what it costs to build something, and how much more they can sell it for, which means profits.
However, you can be profitable without having any money in the bank. And what’s worse is that it tends to happen a lot when you’re growing, which turns good news into bad news and catches people unprepared.
Here are some traps you can watch for, to catch cash flow problems before they happen.
Every Dollar of Receivables is A Dollar Less Cash
Although it’s not intuitive, it’s true that more receivables mean less cash. You can do the analysis pretty quickly. Assets have to be equal to capital minus liabilities, so if you have a dollar of receivables as an asset, that pretty much means you have one dollar less in cash. If your customers had paid you, it would be money, not accounts receivable.
This comes up all the time is business-to-business sales. In most of the world, when a business delivers goods or services to another business, instead of getting the money for the sale right away, there is an invoice and the business customer pays later. That’s not always true, but it is the rule, not the exception. We call that sales on credit, by the way, and it has nothing to do with sales paid for by credit card (which, ironically, is usually the same as cash less a couple of days and a couple of percentage points as fees).
We can use this in making financial projections: the more assets you have in receivables, the less in cash.
Example: A company running smoothly with an average of 45 days wait for its receivables has a steady cash flow with a minimum balance of just a little less than $500,000. The same company is more than half a million dollars in deficit when its collection days goes to 90 instead of 45. That’s a swing of more than a million dollars between the two assumptions. And that’s in a company with less than $10 million annual sales, and fewer than 50 employees.
And the trick is that the profit and loss doesn’t care about receivables. You have as much profit when you sell $1,000 that your customers haven’t paid yet as when you sell $1,000 that your customers paid instantly in cash. Obviously, the cash flow implications are different in either case.
Every Dollar of Inventory is a Dollar Less Cash
When your business has to buy stuff before it can sell it, that’s called inventory. It’s one of your assets. And keeping a lot of inventory can do bad things to your cash flow, unless you don’t pay for it.
This can be pretty simple math. If having nothing in inventory leaves you with $20,000 in cash, then having $19,000 in inventory leaves you with only $1,000 in cash. That is, if you’ve paid for the inventory. That’s because your other assets, your liabilities, and your capital are all the same.
Sometimes, of course, you cannot pay for that inventory, which means you have more payables, and your cash balance is supported by those payables.
The difference in cash with different assumptions can be startling. You can look ahead to see that in a graphic called What a Difference Two Months Makes.
Every Dollar of Payables is a Dollar More of Cash
While receivables and inventory suck up money by dedicating assets to things that might have been cash but aren’t, paying your own bills late is a standard way to protect your cash flow. The same basic math applies, so it you leave your money in cash instead of using it to pay your bills, you have more cash.
It’s called accounts payable, meaning money that you owe. Every dollar in accounts payable is a dollar you have in cash that won’t be there if you pay that bill. The same problem you have when you sell to businesses is an advantage you have when you are a business. The seller’s accounts receivable is the buyer’s accounts payable.
Now I don’t want to imply that you don’t pay your bills, or that it doesn’t matter. Your business will have credit problems and a bad reputation if it doesn’t pay bills on time, or if it is chronically late with the bills. Still, a lot of businesses use accounts payable to help finance themselves.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
