What is cash flow? Why cash matters more than profit
Most business owners believe that the most important indicator of success is profit. That is a mistake which has cost many businesses their liquidity, and some of them even bankruptcy.
Cash flow, that is, the flow of money through the business, shows the truth about a company’s finances. Profit can be shown on paper. Cash has to be in the bank.
In my practice as a business consultant I often meet entrepreneurs who can tell me exactly what last month’s sales were but do not know how much money will come into the company’s account over the next four weeks. This is where the problem starts. For many managers and business owners, finance is “secret knowledge”, and one of the biggest mistakes is to equate profit with cash.
What does cash flow mean?
Cash flow is the flow of money through a company.
Put most simply: Cash flow = cash inflows – cash outflows
If more money flows into the company than flows out in a given period, cash flow is positive.
If more flows out than flows in, cash flow is negative.
It is cash flow that answers the question:
“Does the company have the money for wages, taxes, social security contributions (ZUS), lease payments and growth?”
The profit and loss account does not answer it.
Why does profit not mean cash?
Imagine a company that has sold services worth PLN 500,000.
It has issued the invoices.
In accounting terms, it has made a profit.
The problem is that the customers will not pay for 60 or 90 days.
So the company has sales, margin and profit, but no money in the bank.
That is exactly why a profitable company can lose its liquidity and have trouble paying what it owes. In business practice, this is one of the most common problems of small and medium-sized enterprises.
A business owner’s three financial statements
Every entrepreneur should be familiar with:
1. The profit and loss account (P&L)
It shows:
sales,
costs,
margin,
profit.
It answers the question: “Are we making money under the company’s business model, and how?”
2. The balance sheet
It shows:
the company’s assets,
liabilities,
equity.
It answers the question: “What do we own, and how is it financed?”
3. Cash flow
It shows:
cash inflows,
cash outflows.
It answers the question: “Do we have the money?”
Why is cash flow the most important thing for a business owner?
Let us imagine two companies.
Company A
net profit: PLN 1 million
cash in the bank: PLN 50,000
Company B
net profit: PLN 300,000
cash in the bank: PLN 2 million
Most entrepreneurs will consider the first one better. Banks, investors and experienced CFOs will often choose the second. Why?
Because cash gives security, flexibility and the possibility of further growth. In business you can survive a temporary lack of profit. You cannot survive for long without cash.
The most common causes of cash flow problems
Long customer payment terms
The company is financing its customers instead of its own growth.
Sales growing too fast
Paradoxically, growth often increases the need for cash.
No budgeting
The owner sees the account balance rather than future cash flows.
Excessive investment
The company is growing at the expense of liquidity.
No regular monitoring of the cash conversion cycle (the management of stock, receivables and payables)
Problems become visible too late.
Five questions about cash flow that a business owner should be asking
How much cash do I have today?
How much cash will I have in 30 days’ time?
Which customers hold on to my money the longest?
How long would the company survive without new revenue?
Which decisions will improve cash flow this very month?
Summary
Most entrepreneurs concentrate on sales and profit.
The best business owners also concentrate on cash.
Sales give hope, and profit on paper gives only satisfaction – unless the customers have actually paid. A company can be making a loss and still have positive cash flow, in the form of capital from investors or banks.
Cash flow gives survival and the possibility of growth.
If I had to name one financial indicator that every business owner should understand, it would be cash flow. It is cash flow that most often decides whether a company will grow or fight for survival.
Would you like to learn to interpret the balance sheet, the profit and loss account and the cash flow statement for yourself, so as to achieve better profitability and improve cash flow in your company?
I have prepared a unique course based on my book Finanse dla niefinansistów w praktyce (Finance for Non-Financial Managers in Practice). It is written in plain language by me, a non-finance person who is up to his ears in finance for his clients and knows non-finance people and their needs inside out.