Unfortunately, the owners aren’t feeling it. From their perspective, the company struggled all year and is still low on cash. Without cash in the bank, the company doesn’t feel profitable.
Which brings us to the question I get asked all the time:
If the business is profitable -- WHERE’S THE MONEY?
because profit is not cash.
To understand the full financial picture of how profit turns into cash, you have to look beyond the Profit and Loss statement (aka P&L) to the Balance Sheet. Stick with me here. If you're uncomfortable looking at balance sheets the only way to get comfortable is to start with a few key concepts.
There are dozens of places where your Balance Sheet is connected to your P&L -- In this post, I'll cover the top five.
Here are my nomination for the top 5 places on your balance sheet that have a big impact on how much cash you actually have to pay your bills. You can use these short and sweet explanations as a guide as you go on a treasure hunt for cash.
- Accounts Receivable: AR shows you how much income you’ve booked as revenue but you have not yet been paid. Your clients or customers owe you this money. The income is counted on your P&L – but the cash is not in your bank.
- Prepaid Expenses: This account shows bills you’ve paid in advance of using the material or service. For example, in December you may have paid 6 months of an insurance premium that covers January to June. That’s cash you’ve paid out, but the expense doesn’t show up on your P&L until next year.
- Accounts Payable: AP shows bills you have received, but not yet paid. A reasonable amount in accounts payable helps cash flow because while the expenses show up on the P&L, the cash has not left your bank account yet. Ideally the amounts and timing of what’s due to
you in Accounts Receivable and from you in Accounts Payable are in the same ballpark. But if you have a lot more in Receivables than in Payables your business is essentially
financing your customers. That hurts!
- Loans and Debt Payments: The only part of a debt payment that shows up on your Profit and Loss Statement is the interest paid. All of the principal payments are taken directly off your Balance Sheet. Debt payments can add up to a lot of cash that you need to pay out: payments that do not affect profitability but certainly affect cash.
- Owner’s Draw or changes in Owners Equity. The Owner's Equity account shows both cash that you, as owner, put into the company AND cash you withdraw from the company. This one is tricky, because the account name and use of the account changes depending on how the company is structured. For example. if your company is an LLC an equity draw is the only way to get paid for your work. However, transactions in the Equity account definitely do NOT show up on your Profit and Loss statement. That's right -- for an LLC your owner's pay does not show up on your P&L. You definitely want to include owner’s pay in your cash plan – even if it doesn’t show up on your P&L.
Understanding how these accounts impact cash is the first step toward being able to manage for both positive cash AND improved profits. For example, getting your current customers pay you faster may be easier than increasing sales; or getting a cash flow loan from a bank.
I'll be diving more into managing cash in my next post so make sure you hit the subscribe button below