In a previous blog post, the one where I managed to talk about Alice in Wonderland in relation to finances, I wrote about how producing monthly management accounts based on accruals rather than cash was so important. All the time I talk to business owners who, if they do produce management accounts – and I speak to many who still only produce annual statutory accounts, basically run their business using a cashflow forecast. Their rationale for this is understandable, if I have cash in the bank and that cash balance in constantly going up then I am in a good position. That may or not be true depending on a range of underlying circumstances.
The most dangerous situation is when business owners equate cash with profit. A week rarely goes by without someone assuming that cash and profit are the same thing. This is often more prevalent in service based industries that do not hold stock so the main asset on their balance sheet is often cash. Whilst having positive cashflows and cash in the bank is very helpful to a business it does not mean that they are profitable or will guarantee long term success.
Every hour of everyday extremely profitable businesses go out of business because they run out of operating cash. Similarly there are businesses that are absolutely awash with cash but have never made a profit.
While cash is definitely King for a business – profit and cash are two very separate things. Having cash in your business is essential but it does not mean it is profitable.
How can this be so?
A business can have a significant profit margin but if they cannot collect that cash in quickly enough then there might not be enough working capital to continue operating. Growing businesses consume huge amounts of cash. If you are a Gazelle company, no matter how profitable, when growth is rapid cash is always tight. As soon as a profit is made and turned into cash it will be reinvested in growth – new staff, more stock, improving infrastructure, new product development, etc, etc. Some businesses that are profitable but they are not growing fast also suffer cashflow issues because they are squeezed on payments terms by customers or do not have robust cash management or credit control and their debtor days increase.
The big supermarket chains have had a torrid time in recent years for various reasons. In 2015 Tesco reported an annual loss of £6.4 billion. However, that business has hundreds of millions of pounds literally in cash sat in tills and safes on a daily basis. So hugely unprofitable but with extremely large amounts of physical cash and cash in bank accounts. There was very little chance of Tesco going out of business as it had significant amounts of cash and it could easily meet its financial commitments (and even if cash got tight they could easily squeeze it from their suppliers – see above!)
Companies that are “dying” often have a lot of cash, in the form of retained profits from previous years, and are essentially hemorrhaging cash and will eventually go broke. Kodak is a great example. It was doomed for a long time due to the advance of camera phones and people not printing photographs. However, it kept going for several more years because the business had a lot of cash on its balance sheet so it could continue to operate despite growing losses. The sensible thing to do would have been to liquidate the business sooner and distribute the proceeds to shareholders. However, I am sure the thinking at Kodak was along the lines of “we have the cash to keep going, we can innovate and trade our way out of this situation”.
If in you are still in doubt that cash and profit are somehow related I can give you a cast iron strategy for significantly boosting the cash within your business immediately. Stop paying people. Suspend wage payments and refuse to pay your suppliers. This is guaranteed to boost your bank account but I am not sure it is a long term strategy for profitability and business success.
Forecast and manage your cashflow by all means but it is your monthly management accounts, based on accruals, that tell you how profitable your business really is.