Part 2 of 3… In part 1, we discussed the first 4 fundamental cash flow elements. We learned that Profit is equal to Revenue minus a variety of expenses.
And because all the expenses have been removed, it’s easy to make an assumption that is actually the biggest, most misleading, and potentially dangerous cash flow myth:
Profit equals cash flow.
As any failed profitable business can tell you, this is just not true.
Profit is simply a measure of operational effectiveness. It tells us how much cash our operating activities SHOULD generate, but it leaves out two critical things that can dramatically affect cash flow: timing and things that don’t affect operations. Which, if ignored, can kill the business.
The rule of thumb? Never confuse “profit” with “cash flow.”
5. Timing of Receiving Revenue
Let’s get back to revenue. You’ve done some work or delivered some widgets. You’ve created an invoice and sent it to your customer. Your revenue proudly shows the total of all your invoices. Good work!
And then your customers don’t pay for one month. Or two months. Or, gulp, three months.
Can you see how the timing of customer payments significantly affects cash flow?
Your accounting system tracks how much money your customers owe you in Accounts Receivable. Which is great, but wouldn’t it be nice to know when you’re going to get paid? This is where “Accounts Receivable Days” comes in: it’s the average number of days it takes your customers to pay.
Rule of thumb: Reduce Accounts Receivable Days to improve cash flow. In other words, get paid sooner.
6. Timing of Paying Expenses
Just as your customers pay you, you pay your suppliers. And just as your customers sometimes delay paying you (which worsens your cash flow), you can delay paying your suppliers (which improves your cash flow by keeping the cash in your bank account).
Your accounting system tracks how much money your business owes in Accounts Payable. And the average time you take to pay your bills is known as “Accounts Payable Days.”
Rule of thumb: Improve cash flow by increasing Accounts Payable Days. But don’t wait too long to pay your suppliers or they may not want to have you as a customer.
7. Things That Don’t Affect Operations But Do Affect Cash Flow
Many other things affect cash flow, but keep two in mind for now:
- loan payments, and
- equipment purchases.
Neither of them show on your Income Statement. This makes them easier to forget when you’re thinking about cash flow. But when you forget about your $800 truck payment and the $3,500 you just spent on a new laptop, you can find yourself in a cash flow pickle at the end of the month.
Rule of thumb: Loan payments and large equipment purchases don’t show on your Income Statement but they DO affect cash flow!
Closely and Constantly
Cash is the life blood of every business. It must be monitored closely and constantly. Spend a few minutes with these 7 elements each week and you’ll develop an excellent sense of your business’s cash flow.
Tomorrow: Learn Three Common Cash Flow Mistakes (So You Can Avoid Them)
Free online Cash Flow training! Register for my November 10 session here.