Profits are defined as revenue fewer expenses. They may also be referred to as net income. Cash flows, on the other hand, refer to the inflows and outflows of cash for a particular business. Bringing in profits does not always increase cash instantly and incurring an expense does not always reduce cash instantly.
Let’s assume that company “A” manufactures and distributes lawn mowers to the stores and other retail outlets. Following are the differences between profit and cash flow:
1. Revenue Generated
Company “A” sells an INR 30,000 lawn mower to a retail store on June 1st, and emails an invoice. The business posts INR 30,000 in revenue, but the retailer doesn’t pay the invoice until June 30th. Revenue is posted immediately in the accounts but cash is not collected for 30 days.
2. Expense Incurred
Company “A” pays INR 20,000 in expenses for the lawn mower that was sold. Those expenditures are made in April and May, before the sale of the lawnmower. The business has INR 20,000 in cash outflows in April and May before collecting INR 30,000 on June 30th.
3. Profit Recognized
The profit generated on the lawn mower sale is INR (30,000-20,000=10,000), and that profit is posted on June 1st. In accounting terms, revenue can be recognized on June 1st, because the sales process is completed when the product is delivered. However, the profit of Rs.10, 000 is not collected in cash until June 30th.
While the company A must wait to collect its receivables, other companies do not have this issue. A lot of businesses collect cash from customers at the point of sale. Let’s take the example of Wal-Mart which receives customer payments at the point of sale through debit card and credit card purchases.
This process allows a retailer to collect cash quickly and makes the cash management process much easier.
Cash Flow Management Is Different for Every Business
Company “A” earned Rs.10, 000 profit on the lawn mower sale, but had to pay Rs. 27,000 in cash to make and deliver the product to a customer. The firm also had to wait 30 days after the sale to recover Rs. 27,000 paid in cash and collect the profit. The more products company sells the more cash it must spend. This situation requires precise cash flow management.
Here are several sources of cash flow for the firm:
- Collections on prior sales: Cash collections from sales in prior months can provide cash to make and deliver products. April and May’s sales collected in June can provide cash for June manufacturing costs. However, if the company’s sales are increasing, cash collections from past months may not be sufficient for current production cash needs.
- Delaying cash payments: Firm may be able to delay cash payments, which would reduce the total amount of cash needed for production each month. Assume, for example, that Company “A” purchases metal and other raw materials from Standard Machine. The two parties sign a contract that requires company “A” to deposit 20% of each order in cash and pay the balance in 25 days. This arrangement will improve A’s cash position.
- Raising capital: If “A” cannot finance its cash needs through business cash flow, it may need to raise additional capital. Businesses can raise capital by issuing stock, which means that an investor purchases ownership in the company in exchange for cash. It can also raise capital by borrowing funds.
Raising additional capital is the least attractive option for cash management. If it issues stock, the owners are selling a percentage of their interest in the company. Issuing debt requires the company to make interest payments on debt, and repay the original principal amount borrowed on time.
Most companies must issue stock or debt to raise enough funds to operate the business.
Rapid Growth and Business Failure
It turns out that rapid growth can lead in several ways to the failing of business. The cash flow problem described here is one of the factors where suppliers require quick payment of invoices while wholesale customers pay slowly. The profit issue described above is another which concentrates that increases in production volume take up the costs beyond the breakeven point. According to a study, there are five more contributory issues, all of them affecting either cash flow or profit or both:
- Operational challenges: Increased volumes change operational requirements. Often, businesses in the midst of a growth spurt devote insufficient time to making those changes in time.
- Customer service issues: New and improved products spur sales and also leading to expensive warranty repairs or even product recalls. It becomes challenging for a customer service staff to cater to the increased demands which also leads to customer dissatisfaction,
- Heavy corporate spending: the success of one product may lead the company to make overly-optimistic spending decisions, such as expensive equipment purchases and facilities improvements
- HR Issues: This includes a rapid growth of workers unfamiliar with the existing corporate culture, dissatisfaction of current staff over new supervisors, payroll problems and changes in production methods.
- Leadership issues: often the characteristics of a successful entrepreneur are quite different from the characteristics of a successful CEO of an established company. As a company expands beyond its startup phase, it may require a change in leadership, which is either resisted or unrecognized in a timely way.
Careful Planning of Cash flow
Along with having high profits as a motive, it’s important to have cash needs of your business with a careful planning. Make sure to understand well the differences between profit and cash flow, so that you can grow your business with sufficient cash flow.
In the long-term, one must get profitable eventually or find stock investors to keep supplying you cash to make up for your losses. In the short-term, even if you’re profitable, you survive or fail based on whether you have the cash to pay the bills. That’s why it’s said- Cash Flow is King.