Financial Accounting vs. Cash Flow Management
When you look at your business financials, how do you know if you’re making a profit? Many small business owners use their profit & loss statements (P&L) as the only way to tell if they’re winning. It’s a natural thing to do. After all, the name of the report has profits in it, right? Well, the P&L report is an important tool for your business but it’s not the only tool. In fact, if you’re only looking at your P&L statements, you may not be doing as well as you think.
There’s a difference in how accountants look at your finances and how you as the financial manager of your company should be looking at your finances. In the accounting world, the accrual method is the prevailing technique for tracking financial status. Under the accrual method of accounting I can make a sale today and the income shows on the books today, whether the customer actually pays me or not. Simply said, the money is accounted for when the customer uses or takes possession of the product or service (not when the money exchanges hands).
The problem with this method of accounting is that it doesn’t pay attention to your cash flow. You could be highly profitable on paper, but that means nothing if your customers aren’t paying you. You need the money to actually hit your bank account at some point if you want to stay in business. Lack of cash flow can cause your accounts payable and accounts receivable balances to grow rapidly. This can really mess you up if you’re not careful. It’s important to keep both of these at minimal levels so you can stay on top of the situation and keep your bank account balances in check.
As a business owner it’s important to pay attention to financial accounting, but you absolutely cannot ignore financial management. You have to manage cash flows. There’s a reason I do a cash flow plan for my businesses, not an accounting plan. Cash flow is crucial to staying afloat. Without it, a business cannot operate. I work with a lot of small business owners who are struggling to pay their bills. They all have a similar situation – their accountant says they had a profitable year but they have nothing to show for it.
The problem is they’re not managing the cash flow. On paper they look great, but in their bank account they’re on the verge of bankruptcy. Why? Well, it’s caused by a number of things. Customers not paying on time, spending based on the net profits in the P&L statement (and ignoring future expenses like taxes & periodic payments), not having a plan for the cash flow, etc.
Focus on the Basics
I think at the heart of the problem is just a lack of understanding of the basic principles of financial management. It’s pretty common to find a small business owner who is great at certain skill sets but lacking in the financial and business management knowledge. They didn’t go into business to run a business. They went into business to practice their trade on their own. I get that, but running the business comes with the territory. You’ve got to pay attention to the basic business stuff (or hire the right team member to do it for you).
My recommendation: let your accountants use the accrual method, but don’t run your business based on their reports. You still need to do a monthly cash flow plan, and you need to project that cash flow plan out over the next 12 months at a minimum. The big companies call this their cash budget. They’re required to use the accrual method for their financial reports, but they still do a cash budget so they can make sure they’ll stay solvent throughout the year. You need to do one too.
When your cash flow is suffering
You have to manage your cash flows and make sure it’s actually flowing. If it’s not flowing, it’s time to make some immediate adjustments. If you have a collections problem, it’s time to teach your sales team how to pre-qualify your customers. If you have trouble paying bills in the slow months, it’s time to retain some earnings (50% of your annual expenses) so you don’t have to use credit to meet payroll. If you’re constantly struggling to pay your tax liabilities, it’s time to set aside estimated taxes in a separate account through out the year. If you’re profitable on paper but you aren’t paying yourself anything, it’s time to reevaluate the business plan.
In the world of personal finance, cash is king. In the small business world, cash flow is king. As my business finance professor likes to say, “Happiness is a positive cash flow.” Forget what the accounting reports say. Be an active manager of your business and make sure you’re cash flowing (and retaining earnings) so you can bring home a paycheck. After all, isn’t that why you’re in business?