Why cash flow is king
One of the biggest financial mistakes many small business owners make is focusing too heavily on profitability at the expense of cash flow. There’s an old saying that sums it up well: “Profit is Queen, but cash is King.”
This is especially true in the post-financial-crisis world that continues to linger, with economic growth remaining tepid and most banks still reluctant to loosen the purse strings. Unfortunately, many small businesses that were enjoying record profits, at least on paper, back before the financial crisis hit didn’t have sufficient cash flow to see them through the downturn.
Regardless of where your small business stands today, it’s critical that you understand the difference between profit and cash flow. Doing so may be the difference between whether your business survives, much less thrives, in today’s challenging business and economic environment.
Understanding the Cash Flow Cycle
If sales were made “cash on the barrel,” then cash flow wouldn’t be much of an issue. You’d sell your product, collect payment at the time of sale and deposit your cash in the bank. No fuss, no muss.
But that’s not how most small businesses operate. Instead, most operate on what’s known as a cash flow cycle, which is the time between when cash is paid out (for raw materials, equipment, salaries, etc.) and when accounts receivable are collected from customers. For a manufacturing business, the cycle usually works like this:
- Cash is used to buy raw materials.
- Raw materials are converted into finished goods.
- Goods are sold and accounts receivable are generated.
- Accounts receivable are collected and converted back to cash again.
A simple example helps show what a lack of cash flow can do to what appears, at least on the surface, to be a thriving small business:
XYZ Company launched with $100,000 of cash on hand and a hot new product. The product was so popular, in fact, that it flew off the shelves during the first few months of operations, and the owners were reaping profits right out of the gate—at least on paper. Buoyed by their success, the owners opened a second manufacturing facility to increase production and sales even more.
Six months after starting production, sales were still booming, averaging about $50,000 a month, and the profit margins remained healthy. But a problem was looming: The owners discovered that, rather than collecting accounts receivable in 30 days like they had projected, it was taking closer to an average of 60 days. And a few customers were taking as long as 90 days to pay their invoices!