Manage Right and Steer Clear
of the Perfect Storm - Part
this article, we'll walk through why profits don't
always equal cash, and how to make plans in advance for
required funds using a profit plan and cash budget.
Last month, we talked about how lack of managing your
cash flow cycle can negatively impact your cash flow.
This month, I'd like to talk about profits vs. cash flow
and how seasonal sales can cause you to flounder if
you're not careful.
If you have a cyclical business, then you're familiar
with demands....seasonal stress. In May, you might be
deciding what products you'll bet on for your Christmas
season. In September, you're already taking delivery
(and getting invoiced for) product you're not selling
until December. In December, you may or may not have
some cash in the bank. At that point you've got to
decide how to much to take out, how much to pay off to
vendors, and last but not least, how much to pay off Mr.
Banker. Oh, in the meantime, no matter what your sales
are, you've always got those pesky fixed costs you have
to pay no matter what - payroll, rent, advertising
contracts, term loans, the list goes on and on as you
Whew. No wonder you get stressed out. Profits maybe,
cash maybe. Your cash can lag a month or two behind your
profits, if it ever comes in at all. Up and down.
Remember those monster waves we talked about in our
first article? The good money managers are riding them
out. They know they're coming, they plan for them, they
trim their sales. They might not enjoy them but they're
managing to stay on top. The bad money managers? Well,
they're floundering at best, sinking at worst.
Unlike the local fast food joint. It's pretty simple for
them. They sell a burger, take the dollar or two, buy
some inventory, sell it in a day or two, and move on.
Profits in, cash in. Even if they have a sales spike
during peak months, their cash pretty much stays in
What can you do besides sell your shop and buy a
hamburger franchise? Understand your cycles, get that
excess inventory out of your ballast, and chart a course
(more about how to do that in a bit). Oh, and it helps
to get a handle on the difference between profits and
First, a bit of accounting terminology. For those of you
who hate anything to do with accounting, close your eyes
and join me later. For the rest of you, hang on, this
will be fascinating. Well, maybe not fascinating, but
hopefully a bit enlightening.
vs. Accrual Accounting
get to the root of the question, we need to understand
the fundamental differences between the two primary
forms of accounting: cash and accrual. We also need to
focus on the basic strengths and weaknesses of each
method - especially their weaknesses - because to
measure the strength of a chain you check its weakest
link. Here's the basic comparison:
always know your cash flow
don't know your net profits
always know your net profits
don't know your cash flow
let's review the basic premise for cash accounting: you
recognize income when you deposit receipts and you
recognize expense when you write the check. So the
strength of the system is that you always know your cash
position. But what about profits? Well, let's look at a
typical scenario for a typical group that uses cash
typical farmer grows a crop, then holds it for two
years. In the year he sells he is actually recognizing
income in the current year for a crop grown two years
ago. In addition, he often buys seed for next year and
pays for it this year. So, in effect, he compares
revenue from two years ago against expenses for next
year and really has no idea whether or not he's making a
profit. Profitability is, therefore, the "weak
link" in cash-basis accounting.
just the opposite is true with accrual accounting.
Income is recognized as you earn it, not when the money
is collected; and expenses are recognized when they are
incurred, not when the bills are paid.
by matching the income earned against the expense
generated to earn it, you always get an accurate picture
of profitability. However, the weakness of the accrual
system is that you do not get an accurate picture of the
timing of inflows and outflows of cash; cash flow is the
weak link of the accrual method of accounting.
what to do? The banking industry had two accounting
possibilities, neither of which presented the whole
picture. Enter Excel spreadsheets and the rest.
Essentially, spreadsheets were developed which convert
an accrual statement to a cash statement - to focus on
cash flow. More precisely, to focus on analysis through
the cash account from the statements.
that was a radical breakthrough! Accountants had been
doing it for years, of course - only no one else was
paying attention. Now, Microsoft, et al have provided a
tool that anybody can use. The theory: if the weakest
link is adequate, the whole package will work out.
Outflow . . . GIGO
with this new tool to predict cash flow, banks rushed
out to do battle with business owners. When they
requested a "cash flow," customers could now
go punch up fifty cash flows, each one containing a
different set of assumptions! The new weakness?
Electronic "prettiness." Computer-generated
statements are beautiful, but someone still has to
understand the input - or the output can easily become
Cash Flow: Cash as a Strong Link
only reliable method of managing cash flow is to
evaluate - month by month - the inflows and outflows
from your business. To manage this process successfully,
you must understand the relationships and timing.
Software will help you do it faster; however, you must
tell the software how your business runs.
the patterns of cash and learn what components have the
greatest impact on cash flow. (Namely, inventory and
receivables.) Then, manage those items by tracking your
cash flow benchmarks we talked about in Part I. You will
be able to produce a cash flow that makes sense and
allow you to concentrate on the patterns of cash flow. ~