P1M6 From Profit To Cash Flow

Until now, our talk about finance and performance measurement has concentrated on understanding how to make a bigger profit.

We’ll now turn our attention to the essential topic of cash flow and having money in the bank.

Why Cash Is So Important

To be blunt and brutal a business without cash or spare banking facilities is a bankrupt business.

It’s the inability to pay the wages, salaries and suppliers which causes a business to go bust.

A business may have high sales, even high profit but when the cash runs out…that’s it.


Over the long term, there is a relationship between profit and cash flow but in the short term the relationship can be counter-intuitive.

Remember I told you my favourite financial saying…the Banker’s Mantra

Turnover is vanity, profit is sanity and cash is reality…often the harsh reality.

Flows & Balances

Cash is the best place to demonstrate the two concepts of flows and balances.

Profit is a flow – it is defined by a period of time

£10,000 profit last month

£250,000 profit last year.

Balances are snapshots at a point in time.

There is £6,250 in the bank first thing this morning.

It could be £3 tomorrow or £105,000.

Balances can change dramatically from day to day.

And the change in the balance from the beginning to the end is called a flow.

There are three major statements in a set of accounts from a big public company…together with a lot of notes and explanations.

Two of those statements are concerned with flows:

Both show how well the business has been making money in the period.

The other is the Balance Sheet and the name gives the game away

The Balance Sheet is a snapshot of the balances in a business at a particular time.

I think we should have a look at the Balance Sheet in a little more detail.

The Balance Sheet

A balance sheet is a snapshot of your business at a moment in time.

It doesn’t capture movement but it does see assets and liabilities.

If we ditch the financial jargon for a moment and take it down to individuals.

Your income is the amount you earn in a period – it is a flow and you use it to pay your everyday expenses.

Your wealth is a summary of what you own net of what you owe – it is a balance. It changes each day based on your income and expenses.

So your Balance Sheet is the wealth of your business and your Profit & Loss is your income.

Read: The Balance Sheet

Sales To Cash Receipts

When you make a sale, you will agree certain payment terms with a customer.

It might be cash with order in which case you will be paid in advance.

It might be cash on delivery and you and your customer swap goods for money at the same time.

More likely you sell on some kind of credit with payment due in 14 days, 30 days, 60 days etc of the invoice.

And finally you may sell on some kind of instalment basis.

For example in the big plant & machinery markets you may be asked to pay 20% on order, 20% half way through the machine build, 40% on delivery, 10% on installation and 10% on commissioning.

Or you may sell through a financing scheme with a bank or leasing company where the customer pays monthly but you get your money in 30 days with the bank sitting in the middle.

Two things introduce timing differences between your profit and your cash flow:

1.    Your terms of payment.

2.    How well your customers stick to the terms.

Many small businesses have found it is one thing to agree payment in 30 days with a buyer… it’s another to get the payment out of the accounts department.

A Thought For You

This quote from American marketing expert and entrepreneur Dan Kennedy is interesting.

“Wealthy people make a practice of getting paid BEFORE they do the work.

Poor people get paid after they’ve done the work.”

It’s a question of relative strength and power in the negotiations.

The poor people are desperate for the work and don’t want to frighten the customer away.

The rich people don’t need the work and effectively say:

”If you want me to do that…then you’ll have to play by my rules.”

Two questions for you about how you set your terms of payment with customers:

  • “Are you in a stronger position than you think?”
  • “Can you change your terms and if not for existing customers, can you get better payment terms with new customers?”

It’s easy to fall into the trap of matching what you think others are offering in your market.

Customers for regular supplies may resist vigorously because they rely on credit from their purchases to fund their debtors/accounts receivable.

But what about the web designer who asks for 100% payment upfront and is prepared to settle for 50% upfront and 50% on completion?

Or the accountant who puts you on a direct debit (or automatic credit card payment) each month during the year for services to be supplied rather than paying the bill after the end of the year?

Read: How To Get Your Customers To Pay In Advance

Monitoring Debtors & Accounts Receivable

There are several effective ways to monitor how well your cash collection system is working.

The best established is to represent your Accounts Receivable as the total number of Days Sales Outstanding

Read: Days Sales Outstanding

It is very useful for giving you an overall assessment of the amount of credit you give to customers.

It’s not so good for keeping track of issues if some customers have terms of payment in 7 days, some in 30 days and some in 60 days.

You can identify who is paying late and total up the customer arrears – that is customers who haven’t paid you within your terms or within a reasonable time of the due dates.

Other Cash Receipts

The regular receipts in a business are from customers:

  • advanced payments
  • cash sales and
  • credit sales.

The business can get extra cash in by selling some of its fixed assets – things like cars, surplus plant & equipment, buildings (perhaps on a sale and leaseback arrangement)

The basic rule if you are strapped for cash is:

“If you don’t need it as much as you need the money…  sell it.”

Alternatively you as the owner or owners could invest more money, either as more capital or as a loan.

The business may be given a bank loan or receive a grant.

If you have a cash flow problem you will need to

  • bring in more receipts
  • bring your receipts in faster or
  • pay less out.


The payment for suppliers and vendors is the opposite of the debtors / accounts receivable and you could monitor Days Purchases Outstanding.

Each month you will pay your wages and salaries and pay over the tax you’ve withheld on your employees behalf.

You will also have other payments to be made on fixed schedules.

Perhaps quarterly rent payments.

In the UK small businesses pay their VAT (sales tax) quarterly and corporation tax on profits has to be made by a certain time after the year end.

You may buy new fixed assets – a new car or plant & equipment.

If you have a loan, you will have to pay it back, perhaps monthly or quarterly plus interest of course.

As the owner you may pay yourself a dividend as a tax efficient way of taking money out of the business.

These all make payments fluctuate from month to month and if you don’t expect a big payment month when many things are due, it can give you real problems.

That’s why it’s important to control your cash with regular cash flow forecasting.

When you have a well prepared cash flow with sensible assumptions, you can spot times when things may be tight and talk to your bank in good time.

Cash Flow Format 1 – Receipts & Payments

The most popular type of cash flow for a small business is a receipts and payments report.

Since cash flow in a period is the difference between total receipts and total payments, you can explain your cash flow by analysing each type of receipt and payment I have mentioned above.

On one level a receipts and payments cash flow report is very easy to understand.

Why is cash flow negative this month?

Because we paid out more than we received.

What did we pay out?

Here’s the analysis of cash payments and it’s particularly good if you can compare what happened again what was forecast to happen.

But a Receipts & Payments Cash Flow Report doesn’t link to profit and doesn’t answer the puzzling question

“Where has our cash gone if we have made a profit?”

To find that out you need…

Cash Flow Format 2 – Financial Reporting Standards

There is a more formal cash flow report designed to answer that question which is included in the annual report and accounts for big companies.

This links the Profit & Loss account for a period with the movement in the opening and closing balance sheets.

It starts with the profit made in the period.

Then depreciation is added back. If you’re not sure what depreciation is, then it is a non-cash cost to reflect the value used up for fixed assets over time.

If you buy a car, it loses its value as it gets older and you drive more miles. That loss of value is reflected in the accounts as depreciation but there is no cash effect because you bought the car some time ago.

This second cash flow format then adjusts for increases or decreases in inventories/stocks, debtors/accounts receivable or creditors/accounts payable.

Then it fits in better with the receipts and payments cash flow as it shows assets bought and paid for, loan repayments, business tax payments and dividends paid.

For short term cash flow forecasts I use the receipts and payments forecasts but for longer term cash forecasts I prefer this more complicated version because it explains why profit and cash flow are so different.

Cash Flow Forecast

Cash Flow Actual Reports record what has happened…while a Cash Flow Forecast predicts the future.

The Receipts & Payments format is a great way to control your cash.

If cash flow is tight, you can make your forecast and then track what is happening through the month, perhaps leaving enough in the bank to make sure you can pay the wages and salaries.

If cash is always a problem and you are always at your maximum bank overdraft with payments overdue to suppliers… it is a serious sign of problems…and you should talk to your accountant…because you may need specialist insolvency advice.

I don’t know about the rest of the world… but in the UK… directors can be held personally liable for money owed by the company… if it is bankrupt and… the business carries on trading when there is no realistic hope of improvement.

Sorry to be gloomy but I thought I should make that point. It’s one thing to juggle cash to cover a short term timing problem…another if it is long term.

The purpose of  the Cash Flow Forecast is to see potential cash shortages well ahead of time and take the actions necessary to solve them.

You may be able to bring receipts forward, delay payments or…if necessary…arrange extra banking facilities.

The worst thing you can do is go to your bank when you are at your limit and you have to admit you need more money for the next three to six months.

It sends a clear signal to your bank manager that you are not in control of your business finances…and guess what… banks don’t want to lend to businesses that aren’t in control.

Much better to go two or three months ahead of time and ask for the extra facilities when you don’t yet need it. You still need a good story but your behaviour is sending out a much better signal.

Why Cash Varies So Much

A quick recap on why cash flow can vary so much and why, even if your bank account looks good today…it may not be so healthy in a few months time.

First is the trading cash cycle in your business.

If you sell from stock you may want to carry two month’s worth of inventory…which you have to pay for in 30 days…then you sell it…but your customer doesn’t pay you for 90 days.

It’s a long gap between the date you pay your supplier and you get the money back from your customer…and it needs financing. And as your business grows, this working capital requirement increases.

The second reason is that some businesses are seasonal…and make a very high proportion of their sales in one three month period.

Think of toy shops…birthdays are fairly evenly spread out during the year…and there is a huge surge in business in November and December for Christmas.

The third reason is the periodic payments…you don’t pay anything for a few months…and then you have to pay for a quarter. If you are unlucky you can have a number of quarterly payments on the same monthly cycle.

The final reason are one off events…you decide to buy a new car…and pay cash instead of leasing…or you take out cash for the deposit for your holiday home…you have to make some staff redundant.

Estimating Your Cash Flow Forecast

Finally a few tips on estimating your cash flow forecast.

First…note the words…estimate and forecast

It’s an indication but it is unlikely to be right.

This can get quite complicated so it might be worth buying some special software or paying your accountant to write a simple spreadsheet model for you.

Your short term forecast will be based on unwinding the debtors/accounts receivable and creditors/accounts payable in your balance sheet at the last period end.

Plus the impact of current sales and purchase orders…these are commitments.

Longer term forecasts need to be based on a Profit & Loss account forecast.

Then you will have to make your cash flow assumptions.

Perhaps your business sells some things for cash and others on credit…look back at the proportions over the last six months and make a reasonable estimate of what it will be.

Then look at the Days Sales Outstanding for the last six months which are a much better guide than your official terms. Again work with a reasonable average…and if you need to make improvements…and collect cash faster…do it gradually…and decide how you will make it happen.

Payments to suppliers work the same way but strip out your periodic payments first – your quarterly payment, six monthly payments and annual payments.

For payroll, look back at the last few payrolls for the percentage you pay in the month and the percentage that’s deferred and paid to the government.

Predict the one off events you know about…or are thinking about.

For VAT /  sales tax, you’ll have to work it out in detail…but make sure you are consistent between what you include in receipts from customers and payments to suppliers.

If you have a very good bookkeeper …or you have asked your accountant for help…best practice says you should have a forecast balance sheet for each month of the forecast…or at least the last month.

That proves the assumptions have been correctly applied, that the bank balance in the cash flow makes the balance sheet balance …and checks for anything accumulating in the balance sheet when it should pass through the Profit & Loss account.

Cash flow forecasting can be tricky…the extent you need it depends on…

1)    whether you have plenty of money…if so, you can work with monitoring actual cash flows and look out for trends

2)    whether your business is going through a period of change…getter bigger or smaller…because either can mean your intuitive feel for your business could be wrong.

3)    Whether your business is seasonal…the more last month is different to this month and will be different to next month…the more you need control.

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