Why a Profitable Business Can Still Run Out of Cash

It is one of the most confusing things about running a business: the profit and loss statement shows a profit, yet the bank balance is falling. Nothing is wrong with the books. Profit and cash are measuring different things, and a business can be profitable and still be short of cash.

An example

These numbers are illustrative. A small service business has this month:

• Invoices sent to customers: $40,000
• Of which customers actually paid: $25,000
• Operating costs, all paid in cash: $30,000
• A new piece of equipment bought: $6,000
• Loan principal repaid: $2,000
• Owner draw: $3,000

Profit on the P&L is $40,000 of income less $30,000 of costs, which is $10,000. Cash moved by $25,000 received, less $30,000, $6,000, $2,000 and $3,000 paid out, which is a drop of $16,000.

Same month, same business: a $10,000 profit and a $16,000 fall in cash. Every number is correct; they simply answer different questions.

The five usual reasons

1. Customers have not paid yet. Income is recorded when you invoice, but cash arrives when they pay. The longer they take, the bigger the gap.
2. You bought something that is not an expense. Equipment and other long-lived purchases leave the bank right away, but the P&L only picks up a small part of the cost each year.
3. You repaid loan principal. The interest on a loan appears on the P&L. The principal you pay back does not, though it leaves the bank.
4. Inventory and prepayments. Stock you have bought but not yet sold, or costs you paid ahead, use cash before they show up as expenses.
5. Owner draws and taxes. What you take out personally, and the tax you set aside, are not business expenses on the P&L, but they reduce the cash available.

What to watch

• The Aged Receivables report. How much is owed to you and how old it is. This is usually the biggest lever.
• The Statement of Cash Flows. It shows, for a period, where cash actually came from and where it went.
• Upcoming bills and fixed costs. Payroll, rent, loan payments and taxes have dates. Knowing them in advance is half the battle.
• A rolling cash forecast. A simple weekly view of expected cash in and out over the next 13 weeks, updated as things change, shows a shortfall weeks before it arrives, while there is still time to act.

What you can do this week

1. Run the Aged Receivables report and contact the three oldest overdue customers.
2. List every payment you know is due in the next 13 weeks, by week: payroll, rent, loans, taxes, large bills.
3. List the cash you reasonably expect to receive in the same weeks, based on when customers usually pay, not when the invoices are due.
4. Compare the two week by week and note the lowest point.
5. Decide on a minimum cash balance you are not willing to go below, and check the forecast against it.

Any forecast is an estimate and will be wrong in places. Its value is that it makes you look at cash before it is a crisis, and it improves each time you update it against what actually happened.

Where reporting and a forecast come in

Financial Management gives you a monthly set of reports you can read, including cash flow, built from closed books. A Fractional CFO adds the forward look: a rolling cash forecast, a minimum-cash check and the decisions that follow from it. Both depend on books that are current and accurate, which is why we start there.