During the course of their existence, companies may run into issues for a variety of reasons but there is ultimately one thing that kills them: they run out of cash.  Too many managers and investors become focused on the income statement and balance sheet at the exclusion of the statement of cash flows.  There is one noted investor, Warren Buffett, who watches cash closely.   The reason, “Cash is hard to fudge.”

Why should cash flow be targeted as a key measure of business performance?   Why not use solely profit as is found on the income statement?   The income statement and balance sheet, although very useful, do have all kinds of potential biases as a result of the assumptions and estimates that are built into them.   However, when you look at a company’s cash flow statement you are getting an indirect look into their bank account.

So then, if cash flow is so important, why don’t more senior executives pay closer attention?   Some managers do not understand the accounting rules that determine profit, so they may assume that profit is pretty much the same as net cash coming in or out.   Some managers may think that their daily actions do not impact cash in a meaningful way while others may believe that they do affect cash, but do not know how.   In some finance organizations, they believe that cash is their concern and nobody else’s.

If time is taken to understand cash in an organization, the return on that investment in time can be considerable.   The organization can then see how well they are turning profit into cash.    They can see early warning signs of trouble and take appropriate action.   They can learn how to manage their business so cash flow is healthy.   Yes, cash is an ultimate reality check.

WHY PROFIT DOES NOT EQUAL CASH

Why is profit not equal to cash coming in?   Some differences such as loans received which do not impact the profit and loss statement are pretty obvious.   Others may not be as obvious but you can break them down into three main areas:

-       Revenue is booked at sale.   In many cases a sale is recorded for accounting purposes in the profit and loss statement when a company delivers a product or service.   In many cases, no cash has been exchanged at the time of sale since customers typically have a stated number of days to pay.   So, since profit is partially determined by revenue, a component of that profit reflects a customer’s promise to pay.   Cash flow reflects only cash actually received.

-       Expenses are matched to revenue.  An overriding accounting principle is to match the costs and expenses associated with the revenues generated during a given time period.   The expenses charged to the income statement may not be those that were actually paid during that period.   Many will be paid later when they are invoiced by a vendor.  Cash flow reflects the cash that actually went out the door during a period.

-       Capital expenditures do not count against profit directly.  A capital expenditure does not appear on the income statement when it occurs.   It is only the depreciation that is charged against revenue over time which is based on the useful life of the item that was purchased.   The cash flow reflects a different story as most items are paid for long before they may be fully depreciated on the profit and loss statement.

It is true that in mature, well managed companies, cash flow will more closely track net profit.   Receivables may be collected on a timely basis, payables will be paid, and capital expenditures will be incurred in line with depreciation charges.   However, until an entity reaches, and more importantly is able to manage to, such a state, all sorts of havoc can take place.   It is very easy to reach a state where there is profit without cash.    This is The Danger Zone.

It is also important to keep in mind that you may run into a situation where you have good cash flow without profit.   Say you are a retailer and collect cash at sale.   Your expenses may be paid to vendors at a later time which may lull an owner into a false sense of health.   The cash flow statement may look fine as the business is growing, but if margins and expenses are poorly managed, the owner may find themselves in an unprofitable situation which cannot perpetuate a healthy business.

It is this balance of financial and operational expertise that the partners of B2B CFO^® excel at.   We balance the needs of the business and provide information which leads to informed decisions which are actionable.   We understand that cash and profit are different and a healthy business requires both to be managed.   We conduct a reality check and advise accordingly.

At B2B CFO^® we concern ourselves with the client’s success and aspire for them to attain their goals and dreams.

Cash.  We help you get it.