Why Profitable Businesses Fail, and How to Fix It
Is your business realizing great profits but still feeling the pinch each month? There may be a number of reasons for this, but more than likely you’re experiencing cash flow problems.
It’s a mistake many businesses make – focusing on overall profitability but failing to take cash flow into consideration (cash flow problems are, by the way, the #1 reason why small businesses fail) when reviewing their books.
Believe it or not, your cash flow statement is a truer reflection of your business’ financial health than your P&L report.
Why Cash Flow Trumps Profits
Even if your business is the most profitable in town, but you can still find yourself in a cash flow crisis.
That’s because profit margins (what’s left from your sales revenue after your expenses have been accounted for) only take into consideration your income and expenses at a certain point in time. Cash flow, however, is fluid, harder to predict, and can change from month-to-month depending on circumstances.
For example, a late-paying client or unexpected outgoings can erode cash flow very quickly. As your expenses start to add up and exceed your income, then you have a cash flow problem.
But Cash Flow Doesn’t Equal Profitability
Flip the above scenario on its head – your business is cash flow positive (meaning your income balances your outgoings). Great! However, this is no guarantee that your business is a profitable one. Startups who are yet to break even often find themselves in this predicament, i.e. they are spending more money to get the business started than they are yet to make.
Profitability for the Long-Term, Cash Flow Forever
So how do you reconcile profitability and cash flow management? Look at it this way – realizing a profit is a long-term goal, it takes time. Most businesses will incur losses on the way. Cash flow, however, is a best practice that you need to understand from the get-go, master overtime and sustain for the lifetime of your business. Cash flow really is king.
So how do you reconcile these two success factors?
This is where your financial statements can help. Here are a few tips for leveraging available tools and practices:
- Have a business plan, from the start-up phase through the maturity of your business.
- Conduct a break-even analysis. This is done during the start-up phase and can help you predict when you’ll start to realize a profit.
- Create and manage a cash flow statement. This will help you understand how money is flowing in and out of the business and whether you have enough cash to cover your expenses and growth plans. Consider using cloud-based accounting tools to help simplify your reporting and analysis.
- You’ll also benefit from a cash flow forecast. While none of us can predict the future, you can use historical trends, your business plan, and other sources to project your cash flow for the year. Take into consideration seasonal fluctuations, the cost of marketing campaigns, and so on. Cloud accounting tools can help, but you can also use a simple spreadsheet like this sample cash flow projection spreadsheet here.
- To calculate profitability, you’ll need a profit and loss statement, which shows losses and revenue generated over time.
- The last piece of the pie is a balance sheet. This gives a snapshot of your business assets (what you own) and its liabilities (what’s owed). It’s the best indicator of overall stability and liquidity.
The Bottom Line
Setting-up and staying on top of your financial statements is key to understanding how cash is flowing in and out of your business. Software can help, but get a good accountant too, even if it’s just to get you up and running.
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