May 2009  

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"In the business world, the rearview mirror is always clearer than the windshield."
Warren Buffett

"Instead of giving myself reasons why I can't, I give myself reasons why I can."

"Success is getting what you want. Happiness is wanting what you get."
-Dale Carnegie


Manage Right and Steer Clear
of the Perfect Storm - Part II

In 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.

Seasonal Sales

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 well know.

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 step.

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 cash flow.

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.

Cash vs. Accrual Accounting

To 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:

Accounting Method




You always know your cash flow

You don't know your net profits


You always know your net profits

You don't know your cash flow

Cash Accounting

First, 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 accounting: farmers.

Our 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. 

Accrual Accounting

Conversely, 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. 

Consequently, 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.

A "Cruel" Method

So 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.

Now 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.

Inflow, Outflow . . . GIGO

Armed 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 garbage.

Net Cash Flow: Cash as a Strong Link

The 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.

Study 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. ~


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