In the world of small business finance, a fundamental distinction often overlooked is that between profit and cash flow. While both are critical for a successful business operation, they serve different functions and have distinct impacts on the business's financial health. This article aims to demystify these terms, emphasizing the significance of cash flow in maintaining a robust operational foundation.
The value of now: the primacy of cash flow
Let's consider a hypothetical scenario: your enterprise, a niche tech solutions provider, secures a lucrative contract valued at $100,000. This sum represents your revenue. After deducting operational costs—including salaries, utilities, and software licenses—your net earnings amount to $75,000. This figure is your profit. However, if the client's payment terms extend over a longer period of time, your immediate accessible cash from this deal is significantly less, illustrating the difference between profit and cash flow.
Extending our example further, let’s say your client decides to pay you in 6 equal monthly installments instead of an upfront payment. Although this ensures a steady inflow of cash, you're essentially receiving money in parts which have depreciated in value over time. This delay can impact your ability to make immediate reinvestments, cover unexpected costs, or take advantage of timely market opportunities.
In a world driven by immediacy and rapid technological advancements, the "now" has never been more valuable. Immediate payments or shorter payment cycles ensure that businesses can swiftly adapt, innovate, and lead. Waiting for future payments, especially in an era marked by inflation and economic uncertainties, can diminish the purchasing power of money, thereby reducing its actual value.
What are hidden cash outflows?
Hidden cash outflows will not immediately affect the profitability but can drain cash resources, leading to situations where businesses show a profit but are cash flow negative. Here are 10 key examples:
- Capital expenditures: When a company invests in new equipment or a new facility, it's a significant cash outflow. While these investments provide benefits over several years, the immediate cash outflow can be substantial. However, only the depreciation or amortization that is spread over several years would affect profitability.
- Loan principal payments: If your business has taken out loans, the interest on the loan impacts the net profit. However, when you repay the principal portion of the loan, it does not appear under costs. Instead, it's a reduction of the liability on the balance sheet. This repayment can lead to significant cash outflows without affecting reported profits.
- Inventory purchases: Buying large amounts of inventory represents a cash outflow, but this does not immediately impact the profitability. The cost of inventory will only affect profit when the goods are sold. In the interim, the cash is tied up in stock.
- Tax payments: Taxes payable are often based on the previous year's earnings. If a company had a very profitable year last year and needs to pay taxes this year, that can lead to a substantial cash outflow, even if this year isn't as profitable.
- Dividend payments: Dividends paid to shareholders represent a direct outflow of cash but don't reduce reported company profits. Instead, they're distributions from retained earnings.
- Acquisition of other businesses: If a company decides to acquire another business, the purchase can lead to substantial cash outflows, especially if done in cash rather than stock. The expenses related to this acquisition, such as goodwill, may not immediately hit the profit but can impact cash flow.
- Advance payments to suppliers: At times, to secure a better deal or ensure delivery, businesses might make advance payments to suppliers. These payments might not be reflected as expenses until the goods or services are actually received.
- Deposits and prepayments: Security deposits for office rentals or prepayments for services or licenses can represent significant cash outflows without an immediate corresponding expense.
- Settlement of lawsuits or fines: Settling lawsuits or paying off fines might not be part of regular operational costs and can represent unexpected cash outflows.
- Employee bonuses and benefits: Often, bonuses and certain benefits are accrued over the year but paid out at the end or the beginning of the next year. The expense might be spread across months, but the cash outflow happens at once.
Real-world illustrations of cash flow challenges
While profitability is a hallmark of a thriving business, cash flow holds distinct advantages due to following core reasons:
- Liquidity: Adequate cash flow ensures that businesses can meet immediate financial obligations, from payroll to utility bills.
- Stability: Consistent positive cash flow creates a financial buffer, shielding businesses from market volatility or unforeseen expenses.
- Expansion: Liquid assets allow businesses to capitalize on growth opportunities, from technology upgrades to strategic investments.
There are many noteworthy examples of prominent businesses facing cash flow challenges despite being profitable on paper:
Sears Holdings Corporation
An American institution for more than a century, Sears was once the largest retailer in the world. While it had been profitable for decades, a combination of increased competition, significant long-term leases, and extensive debts drained its cash reserves. Despite its brand legacy and profitability from various segments, it could not manage the negative cash flow stemming from its debts and operational costs. By the time it acknowledged the dire need for a transformation, it was too late to stave off bankruptcy in 2018.
J.C. Penney
Another iconic American retailer, J.C. Penney, faced similar challenges. While the company managed to post profits in several quarters, it faced cash flow problems stemming from high levels of debt, expensive store leases, and a retail landscape that was rapidly shifting online. A series of strategic missteps combined with these cash flow pressures forced J.C. Penney into bankruptcy in 2020.
Eastman Kodak
Kodak, once synonymous with photography, faced its downfall due to a mix of technological disruption and financial mismanagement. Even as it reported profits from certain business areas, Kodak's delay in embracing the digital photography revolution and its substantial pension liabilities drained its cash reserves. The company filed for bankruptcy in 2012.
These cases exemplify the critical importance of cash flow management. A brand's legacy or profitability in certain sectors isn't always enough to sustain a business when it fails to manage its cash effectively.
Key takeaway
For small business owners, the key takeaway is clear: while profit indicates success and growth potential, cash flow remains instrumental in day-to-day operations. It's critically important to maintain a strategic focus on cash flow management, ensuring the business remains agile, solvent, and well-prepared for future opportunities.