The Biggest (and Most Misleading) Cash Flow Myth

For Business Owners Only

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.”

Here’s why.

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.

7 Basic Cash Flow Elements – Part I

For Business Owners Only

Once a year I teach an entrepreneurship course at the University of Victoria. Single biggest comment from the students? “You say the word ‘cash’ too much.

Yes I do. Because 82% of businesses that fail, fail because of cash flow problems. So I’m going to keep saying it until that number drops significantly!

Here’s the first of a three part article on 7 basic cash flow elements.

The 7 Basic Elements of Cash Flow

The 7 basic elements of cash flow introduce key terms that the business owner will use throughout her career. They inform her about her cash flow and allow her to make appropriate, timely decisions. And the 7 elements naturally lead to more sophisticated financial literacy topics when the time is right.

1. Revenue or Sales

Revenue is the source of sustainable cash flow. If you create invoices for your customers, then revenue is the total of those invoices.

If you’re in a cash business, then revenue is the total cash that you receive from your customers.

Rule of thumb: Increasing revenue should increase cash flow.

2. Sales and Marketing Expenses

Sales and marketing activities create revenue. They bring appropriate customers to us and convince them to purchase.

There’s always tension in the minds of business owners about these expenses: we must spend money to find new customers and convince them to buy. But spending money reduces cash flow. So we’re always balancing the money we spend on sales and marketing with the revenue that they generate.

To reduce the tension, it’s very important to track the effectiveness of sales and marketing activities: they MUST generate significantly more revenue than they cost. How to do this is a topic for another day, but the rule of thumb is this:

Healthy cash flow needs sales and marketing activities to generate significantly more revenue than they cost.

3. Cost of Goods Sold (COGS)

When a customer buys a product from us, we incur costs related to acquiring, producing, packaging and shipping that product.

This is also true when we deliver a service to a customer: we have labor or technology costs to deliver the service.

The rule of thumb is simple: The smaller our costs of goods sold, the better our cash flow.

4. Other Expenses

In addition to sales, marketing and COGS, there are many other potential expenses that reduce cash flow: staff, rent, communications, travel, accountants and lawyers, etc.

The rule of thumb: Spend as little as you can without affecting your ability to operate effectively.

Interregnum: Profit

Everything in these 4 sections appears on the Income Statement (or Statement of Profit & Loss). Revenue is shown at the top and everything else is subtracted from it to create the “bottom line”. When our revenue is greater than all the expenses, the bottom line is a positive number called profit. When revenue is less than expenses, the bottom line is negative and is called a loss. Which leads us to The Biggest and Most Misleading Cash flow Myth

…which we’ll discuss in Part 2.

BTW, want to get some great, free online training on cash flow? Learn more about my session on November 10 here.