Where’s My Profits?

A conversation this week once again reminded me of the importance of understanding financial tools and what they mean in order to understand what is happening in your business. A frequent misunderstanding by new (and at times not so new) entrepreneurs and business owners is to believe that the net profits line of an income and expense statement represents money in the bank. Often this is not true, because the income and expense statement does not take into consideration the timing of cash flows.

A typical Income and expense statement will record revenues at the top, and then the cost of doing business (or cost of sales), the latter generally being the direct cost to produce what is sold. Once the cost of doing business is subtracted from revenue, what remains is the gross profit.

Next, other expenses, such as salaries and benefits, the cost of a building and utilities and other costs not associated directly with producing a product or service are tallied up, leaving the profit before taxes. Once a provision is made for taxes that the company pays, you have net profit. This is where the misunderstanding occurs. It is true, that from an accounting point of view, the sales and expenses happened during that month, but the real question you need to ask in order to see “what money is in the bank” is, when did these various transactions create actual cash flow into or out of the company.

Now, a business may have had sales during the month, but were they all cash sales, or do some of their customers have terms such as net 30 or net 60. For example, if a company has sales arrangements where half of their customer pay cash, a quarter pay net 30 and a quarter pay net 60, then the actual cash inflow will be only half of what is indicate in the income and expense statement.

The business in question may also have terms, and pay some of its bills cash, others net 30 or net 60, for example. Based on this, the cash outflow for the cost of doing business may also differ. One thing usually does not differ, and that is the other expenses, such as salaries, benefits rent and utilities; these must be paid. These expenses also represent a cash outflow.

Once you determine the actual cash inflow from revenues and the actual cash outflow for various expenses, you would know what your cash in the bank is for the month. Added to the cash leftover from the previous month (if there is any) and you will know where you stand for cash at the moment. The important thing to remember here is that your cash balance and your net profits may not be the same number, depending on when the cash is actually flowing into and out of your business.

2 thoughts on “Where’s My Profits?

  1. Cristina Calinescu

    Misunderstanding of the meaning and the difference between net income and existing money in the bank happens to many of the executives. This is why it is necessary for P & L to be made depending on cash flow, cash inflows and outflows during the reporting period.

  2. Kevin R Callahan

    Cristina,

    You make a good point! Simply looking at a P & L without reference to cash flow can lead to problems. The savvy CFO or financial advisor knows how to help an executive understand the relationship between financial instruments.

    Kevin

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