It’s Cash That Counts

I was working with an entrepreneur in startup mode recently, and was once again reminded of the difference between profits and cash. Particularly in startups, but also in more mature companies that achieve a breakthrough of some sort, mistaking profits reported on an income and expense statement with cash in the bank could be a crucial error. How do people make this mistake?

They do so by not taking into account the timing of cash flows. Remember, an income and expense sheet is reporting sales and expenses as they are booked for accounting reasons, but the cash flows that accompany the sales often do not happen at the same time.

For example, unless they are in retail, most companies do work on a credit basis (when retail accepts a credit card payment, they deposit slips like cash, so there is no extended term). You may not think about that way, but terms like Net 30 or Net 60 are nothing more than extending credit to your clients. In other words, your company is financing your customers’ purchases. The longer that it takes to be paid by your customer, the larger the debt that you finance.

Every company has a cash cycle, and depending on the business that you are in, there are more or less components to that cash cycle. Let’s take a company that distributes materials to other businesses. Here is a view of their cash cycle:

1. Purchase materials on credit terms (Net 30, 60, etc.) from suppliers
2. Hold in inventory
3.Repackage and sell to customers on credit terms (Net, 30, 60, etc)
4. Paid by customers
5. Pay suppliers

Now, this is a simplified cash cycle, but you get the idea. Obviously, if your customers are slow to pay you and you must pay your suppliers, you could be in for a shortfall of cash. Actually, one of the greatest risks to a startup or small company that is trying to grow is running out of cash while the business is expanding quickly. We should also note that there are other expenses (salaries, benefits, office space or utilities) that must be paid even if your customers are not quick paying you.

That brings us to the concept of Working Capital. Working Capital is the amount of cash that your company needs to have available in order to keep the cash cycle going or better put, to keep the company going. Working Capital is usually tracked in a type of spreadsheet known as a Capital Balance Sheet (which is a bit different than a Balance Sheet).

In a regular balance sheet, capital is kept above and debt below. In a capital balance sheet, a certain portion of debt is brought above. Here is the outline of a how to calculate Working Capital in a simple capital balance sheet:

Receivables (what your customers owe you)
+ Inventory
+ Current Assets
– Payables (what you owe your suppliers)
= Working Capital

Working capital represents the cash that a company needs to keep on hand to operate with receivables, inventory and payables. Receivables represent the cash that you have invested in materials and financing your clients. Payables are what your suppliers have invested in your company.

If the company sells $10,000 worth of materials in a month, 50% at Net 30 and 50% at Net 60, it means that they will not collect any cash for at least 30 days (if the customer pays on time!), and some of it not for 60. Even so, after expenses they might show a net profit of $1,500. There’s the rub, the net profit is not cash in the bank! If the company has bills to pay this month (or salaries) they must use the cash flow from previous sales to pay.

A startup company, in particular, will have problems if as they grow they do not have adequate cash in the bank to pay for expenses while waiting for cash to flow from sales. Often, a portion of the original investment capital in a new company is put aside for Working Capital; other means of having working capital at the ready could include a line of credit.

This is precisely what is meant by being adequately capitalized. Working with investors, bankers and others, the company’s executives must ensure that they have the cash in the bank to operate or they will literally be “out of business”!

8 thoughts on “It’s Cash That Counts

  1. This is an article I relate to, so I thought I would share with you a rather surreal conversion I had recently!

    Although I advise upon commercial contracts rather than matters financial, I am the Auditor of a local community group and have also recently been appointed as Treasurer of another. This, latter group, like many organisations, requires 2 signatories on each cheque.

    Because committee members are often away on holiday or business, payments are sometimes delayed and as I like to pay within our suppliers’ terms and conditions, I recently offered one such supplier – a small local business which we pay the same monthly sum to – the option to take payment by standing order.

    In response, he firstly told me that he was going to have to cancel many of his customers’ orders because he had just been going through his accounts and ‘realised’ that they were not paying him (at all!) Then, he said that we were ‘good payers’ and so he’d prefer to keep the current system.

    His final (telling) comment, was that he didn’t know how much longer he would stay in business anyway!!

    It’s an old saying I know, but ‘Turnover is Vanity, Profit is Sanity but Cash is Reality.’ How daft do you have to be to turn down up-front or standing order payments?

    In fact, I was on the other end of such a situation many years ago when the company I was employed by at the time called in consultants to improve their purchasing systems. The main piece of advice they got was – ‘Your suppliers think you are great. They’d give you much better credit terms if you asked – but you never do!!’ (And they were an interntional company – so it seems that some things never change.)

    • Kevin R Callahan

      Two great stories, Margaret! When you are out there working among different companies, you really do find some “head-scratchers”! Thanks for posting.


  2. […] October 20, 2009 in Uncategorized Kevin R. Callahan  in his blog, The COO’s Bulldog, discusses the difference between profits and cash.  Startups, sometimes mistake profits on the income and expense statement with cash in the bank which can be a crucial error….(read more) […]

    • Kevin R Callahan

      For my readers: this is actually a link to a posting about my blog on another site, “Entrepreneur BizPlans’s Blog” Almost like a mutual admiration society! I did find some interesting reading on the site, so why not take a look.


  3. Kevin,
    Thanks for your article. An expense that I expect is misunderstood by many startups is debt amortization. In the early years, while there is adequate annual depreciation, debt can be amortized with pre-tax cash flow (depreciation being a non-cash expense). But as a company ages, and if depreciation was accelerated, then debt needs to be repaid with after-tax cash flow. So it is possible to have a “profitable” and cash generating company that can’t amortize its debt. While I don’t know this, I imagine that this is the cause of a lot of thinly capitalized entrepreneurs going out of business.
    As an aside, this also may explain why high marginal tax rates are devestating to business formation. Owners of marginally profitable pass through entities have difficulty paying their taxes and amortizing their companies debt. So when marginal tax rates are high, marginally profitable companies either shouldn’t be started, never get started, or if started, they fail, especially when follow-on credit is difficult to obtain. And since most new companies are at best marginally profitable in the early years, this is a real problem for business formation and job creation.

  4. Kevin-
    Interesting article. I work for a major athletic footwear and apparel company, and we really rely on credit when working with our various major retail accounts. Although the situation has improved within the last few months as the economy seems to be slowly improving, we were facing a difficult situation as we had product received into the US and ready to go to our accounts but because our accounts could not get the cash or credit they needed to pay us for past orders, we couldn’t ship out their new orders to them, unfortunately resulting in held inventory, which surely did not reflect well on our balance sheets and financial statements.

  5. Kevin R Callahan


    Thanks for the post. As you point out so well, the credit crunch of our current economy is certainly having an effect on balance sheets and financial statements. Hopefully, you have either the cash and/or credit yourselves to support the working capital requirements of your current situation.

    You also illustrate how the credit crunch moves up the supply chain. If you cannot move your inventory, then you either produce less or acquire fewer finished goods. Eventually, the suppliers of materials to the manufacturing process also feel the crunch.

    Best of luck!


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