Cash versus profit, why profitable companies run out of money

Every year we meet BC owners whose year end statements show a healthy profit while their bank balance says something else entirely. They are not doing anything wrong on the income statement. The problem is that profit and cash are different things, measured in different ways, and growth pulls them apart.

Understanding exactly where the cash goes is the first step to managing it. Here are the five places we look.

Receivables grow before revenue is collected

When you invoice a customer, the income statement records the revenue. The cash arrives weeks later, if the customer pays on time. A company that doubles its sales doubles its receivables, and the money to fund that gap has to come from somewhere. It usually comes from the owner delaying their own pay or stretching suppliers.

Measure the average days it takes customers to pay, from your own receivable history. Every day you can shorten it is cash returned to the company permanently.

Inventory and work in progress tie up cash

Goods bought for resale, materials bought for jobs and work done but not yet invoiced are all assets on the balance sheet. None of them are expenses yet, so they do not reduce profit. All of them were paid for, so they reduce cash. A distributor that builds stock ahead of a season, or a contractor with a large job in progress and progress billing lagging behind, is profitable on paper and short of cash in the bank.

Track inventory days and unbilled work every month. Bill as early as the contract allows and count stock often enough to know what is slow moving.

Payments that never touch the income statement

Several large cash outflows are not expenses. Loan principal repayments reduce a liability, not profit. Equipment and vehicle purchases become assets and are depreciated over years, while the cash leaves this month. Owner draws and dividends come out of equity. Income tax instalments and the net sales tax you remit are liabilities being settled.

A company with a healthy operating profit can see all of it leave through these doors. Put every one of them on the cash forecast so they are visible before they land.

Deposits and timing on both sides

Customer deposits received in advance are cash now and revenue later, which flatters the bank balance until the work is delivered and the costs arrive. Supplier deposits are the mirror image. Seasonal businesses feel this most, with sales tax collected in a peak remitted during a trough. Timing differences are not problems on their own, but they must be forecast or they become problems.

The same applies to annual payments. Insurance premiums, software renewals, property tax on an owned premises and equipment maintenance contracts are expensed evenly across the year on an accrual statement, which smooths the profit line, while the cash leaves in a single month. List every annual or quarterly payment with its date so the forecast carries them in the right week.

Reconcile profit to cash every month

Ask your bookkeeper or controller for a simple monthly bridge: start with the month's profit, add back depreciation, subtract the increase in receivables, inventory and unbilled work, add the increase in payables and deposits, subtract loan principal, equipment purchases, owner draws and tax payments, and the result should equal the change in the bank balance. The first time you see this bridge, the mystery usually ends.

Pair the bridge with a 13-week cash flow forecast. The bridge explains the past month and the forecast protects the next quarter. Together they give an owner a complete picture of the company's money.

Once the bridge is routine, set a minimum cash balance for the company and a target for the number of weeks of fixed costs you want to hold in reserve. The bridge tells you whether you are moving toward or away from that target each month, and the forecast tells you when you will get there. Growth decisions, from a hire to a new truck, are then tested against the reserve rather than against the current bank balance.

Signs the gap is opening

• The operating line is drawn higher at the end of each month than the one before
• Supplier payments are being timed around payroll
• Receivables are growing faster than sales
• The owner has not taken a full draw for several months
• Remittances are being paid late to fund operations