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Imagine this: You’re meeting with your accountant at year-end to review your tax return and you get awesome news. Your business made stellar profits! But now, you’re wondering how the heck you’re going to pay income taxes — you’re pretty sure there was no cash in your bank account.

How does it make sense to be profitable but have no money?

As shocking as it is, this scenario is more common than you think. Many business owners confuse the terms “cash flow” and “profit“, thinking they are interchangeable, but they actually represent two very different financial measures of success. If you’re unclear on the difference, you’re not alone!

The distinction between the two is so important that I’m dedicating my first-ever business finance blog post to it! Cash flow is a cornerstone concept behind many of my finance-related posts, and we can never talk about this enough.

As an accountant and entrepreneur, I truly believe this:

Understanding and managing your cash flow is the key to running a successful business.Click To Tweet

 

So let’s get enlightened, shall we?

WHAT IS CASH FLOW?

You’ve heard the saying “Cash is King”, and you know it’s important, but what does it really mean? To better understand this, think of sales as the muscles of your business, and cash flow as its lifeblood.

A healthy business has regular cash flowing in from its sales of services or products, with enough to cover the cash flowing out to pay salaries, buy materials, and pay rent and taxes.

Timing is the key consideration — the art of cash flow management is controlling the timing of when you get paid by your customers — cash in, while ensuring you have enough cash on hand to pay your bills at the end of the month — cash out.

If more money is coming in than is going out at the end of the month or year, you have “positive cash flow” and money in the bank, baby!

If more money is going out to pay bills than is coming in from sales, you have “negative cash flow“, and you will need to find money from other sources to cover your overdrafts. This is a very common scenario for start-ups, but it is crucial that this does not continue in the long term if you want to stay in the game!

WHY DOES CASH FLOW MATTER?

Many businesses struggle with day-to-day operations, or can’t grow because they run out of money.

The lack of cash is one of the major reasons startups fail — According to the Bureau of Labor Statistics, about 20% of small businesses fail in their first year, and about 50% fail by their fifth year.

FREE GUIDE - 12 Easy Strategies to Make More Money

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Grab your FREE 20-page guide now! You'll get 12 easy strategies you can start implementing in your business right away to CONQUER YOUR CASH FLOW!

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WHAT IS PROFIT?

Profit (also referred to as “net income“) is an accounting concept meant to show the bottom line as a factor of when revenues are earned, and matching them to the related expenses, but it does not consider the timing of when the money is actually collected.

The calculation of profit also differs depending on which method of accounting is used in your bookkeeping:

  • Accrual basis of accounting means that you recognize your income and expenses when you earn or incur them.
  • Cash basis of accounting means that you recognize the income and expenses when cash is exchanged.
 INSIGHT:  If your business runs on the accrual method of accounting, there will likely be a difference between cash (ie. money in your bank account) and profits. Note that business taxes are calculated on your profit, so make sure you are working with a qualified tax professional so you know what to expect during tax time.

>> Also Read: The Ultimate No-Bull Explanation of Profits & Margins

A SIMPLE EXAMPLE

To illustrate the difference between cash flow and profit (calculated on an accrual basis), let’s look at some numbers — after all, numbers don’t lie!

The Details
Sample Company has completed some client work on Jan 15, and has billed the client $100 for the service, giving them up to 30 days to pay the invoice.  On Jan 31, monthly employee payroll of $25 is run.  The client pays their invoice on Feb 1, and the month-end payroll of $25 is run on Feb 28.

Below is how the same scenario would be presented in the January and February calculations of cash flow and profit, along with the year-to-date (YTD) total:

cash flow vs profit example illustration

As you can see from above, it is entirely possible to appear “profitable” in your business, while having no cash — this was the case in January.

Because Sample Company didn’t get paid for their work in January, they would’ve had to fund the $25 shortfall needed for employee payroll through some other means, such as: bank overdraft, borrowing on a line of credit, or using personal funds.

HOW CAN I BETTER MANAGE CASH FLOW?

➤  Calculate your net cash flow at least every month, and on an annual basis to stay on top of your net cash position and avoid any surprises.

➤  Use professional accounting software such as Quickbooks to quickly see real-time information on your cash balance and show you the difference between cash and accrual net income.

➤  Work with a qualified accounting or tax professional who can advise you whether cash or accrual method of accounting makes more sense for your business, and keep you updated on your tax obligations.

➤  Collect payment from your customers as soon as possible to advance cash inflows to your business, while delaying cash outflows as reasonable.

➤  Grab my FREE Guide: “12 Easy Strategies to Boost Your Business Cash Flow and Make More Money” for more practical tips you can start implementing in your business today!

 

Cheers,

 

 

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FREE GUIDE - 12 Easy Strategies to Make More Money

Ebook (small) 01

Grab your FREE 20-page guide now! You'll get 12 easy strategies you can start implementing in your business right away to CONQUER YOUR CASH FLOW!

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