Of all the business owners I’ve spoken to, most talk about 2 things: cash balance and profit.

But very few deeply understanding the relationship between them, which leads to frustration and cash flow problems.

Today, I will break down the difference and provide a few examples of how you can better manage your cash.

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WHERE DID ALL THE CASH GO?

If I’ve heard it once, I’ve heard it a million times.

“We’re making money, but where is the cash?!?”

Great question, friend.

And here it is: Profit does NOT equal cash.

Many business owners look at only 2 things:

1. Cash balance
2. Income Statement

But when the Income Statement is telling you you’ve made money, but your cash balance is going down, it can lead to you feeling like you’ve lost control.

Profit comes from the Income Statement and reflects Revenue and Expenses. But Revenue does not mean cash came in the door and expenses do not mean cash has left the building.

Revenue is actually a reflect of a product or service sale, not the money being received.

Expense is a reflection of when the cost is incurred (agreed to or matching revenue), not when it’s actually paid.

This is helpful, as it gives you an accurate reflection of your obligations and the money you’ve theoretically made, but cash should not come for another 30, 60, or 90 days.

This is what makes cash management so hard.

So, we have to consider our sources of cash. You get cash from:

• Cash received related to sale (different than Revenue)
• Sale of an asset
• Taking out loans or other notes
• Capital Contributions by owners/shareholders

Cash goes out the door when you:

• Buy an expense
• Buy an asset
• Repay Debt
• Pay dividends to owners

Of these, only expenses and revenue could potentially be immediately reflected on your Income Statement.

Let’s try an example

I know we’re getting deep here, so let’s use an example.

Widget Co buys 100 units of Widget A for $1,000 on April 30th.

They have to pay when they buy, so they have $1,000 going out the door.

They will sell the units for $22, so to get the $1,000 back, they need to sell AND collect cash on 47 units sold.

But, their customers are on 30-day terms. That means they can buy the widget and take it without paying for 30 days.

So if the customer buys 47 Widgets on May 5th, Widget Co may not receive their money until June 4th.

But, they’re still not better off. So they have cash and profit, but they’re only up $34 in cash from where they started.

To actually be better off, they need to sell 44 MORE units. But now they’ve sold 91 units (47+44) and need to repurchase! So, if they were to purchase 100 more units, they’re depleting the cash that came in and are still only $2 positive from where they were before they bought the first 100 units.

Scenario A

At the end of the day we show:

• Revenue $2,002
• Profit $1,092
• Cash $2

WHERE’D THE CASH GO? Back into inventory…

You can see where this cycle, if not managed well, can be exhausting for business owners.

Now imagine demand has increased… as growth happens, stress on cash just increases and increase until the line is so thin and it BREAKS. That means they’re either unable to:

1. rebuy inventory, losing on sales and customers
2. pay their other bills, letting down their employees

So, how do we fix this?

What if the customers pays when they buy?

Now imagine a scenario where the customer has to pay at purchase. Now, by May 25th we have enough cash to rebuy without running out of cash and if we sell at the same rate can rebuy again by July 14th.

Scenario B

What if we had terms on our inventory?

Now imagine you had 30-day payment terms from Supplier Co AND got immediate payment from your customer.

With this one small change and you’ve now received payment from your customer on 91 units before ever having to pay your supplier.

In this case, your cash balance can actually outpace your profits.

Scenario C

In these 3 scenarios, you can see how you go from having 1 inventory turnover in Scenario A, to 2 in Scenario B, to 3 in Scenario C.

It’s only when inventory turns that cash balances converge again. But remember: they’re converging because they’re scaling.

This directly affects how quickly you can scale as a business.

Comparison

When we compare the 3 scenarios, Scenario C has 5x the cash balance of A and 2.5x the balance of B (assuming they all start with $1,000).

Other factors

In this example, we just reviewed cash in an inventory situation, but cash is also needed for reinvestment in assets and paying other expenses.

Assets or machinery that are required to run the business are irregularly replaced, so it makes it even harder to manage your cash balance. Just as you start to feel comfortable with where you are, you need to replace a long-term asset.

But, these sorts of cycles also mean you can’t take the money out. So, as a business owner, you have a valuable “asset” in this company, but you’re seeing no reward.

Very frustrating, indeed.

Wrapping it up

So, ideally, a business will have:

• Favorable terms on inventory
• Customers paying immediately
• Little or no reinvestment is needed in the business

If you meet these criteria, the dollars made in “profit” become available to do as you please.

Next week we’ll talk about the Cash Conversion Cycle and how that plays into this scenario. It is honestly one of the single best metrics you can use to understand your cash.

By mastering it, you can gamify cash collection so that you never again have to as “I see profit, BUT WHERE’S THE CASH?!”

THINGS OF INTEREST

In writing up this newsletter, I came across an article done by Vox talking about Amazon’s lack of profit and overall plan.

They do a great job of breaking it down, so I thought I’d share it here as some extra reading for those who are interested.

While their revenues climb, their profits have stayed low. But, it’s very deceptive… what do they really care about? Free cash flow.

We’ve talked about it in the newsletter before and I’m sure we’ll talk about it again.

But until that time, enjoy this read.

Thank you for reading--see you again next week.

If you're interested in learning more, here are 3 ways I can help:

1. ​Purchase the Financial Statements Decoded eBook.
2. ​Join the waitlist for my cohort Financial Statements Decoded. Next one is in January!
3. ​Work with me 1-on-1 to optimize your financials and create a financial dashboard that will increase profit (booked through November 2022).