Why Profits Don’t Equal Cash Flow

This is the fourth article on “profitability”—a guide to help understand and develop the true significance of its impact on a business: revenue growth, peace of mind, and freedom to do whatever you want to do.

The biggest question I get all the time is “I’m profitable, so why am I always short on cash?”  Why doesn’t abundant profitability equate to abundant cash? The answer is complicated, complex, and not easily simplified, but…

The short answer – Abundant profitability does produce abundant cash in the bank but it takes a while and is a result of following these rules.

1) There are no draws or distributions to pull cash out of the business.

2) The business doesn’t have wide swings in revenue within the year.

3) The business is consistently profitable.

4) There are no payments on long term debt.

5) Capital expenditures are financed, not paid for with cash.

6) Accounts receivable and/or inventory doesn’t grow (a/r is collected under normal terms).

Break any of these rules and it will impact the conversion of profit into cash.

Maybe a story will help illustrate this.  Joe’s company is consistent: consistently generating $250k a month in revenue and consistently making $25k a month in profit.  Month over month and year over year, this is Joe’s company, never a variation.  Let’s assume that it takes 60 days to collect Joe’s accounts receivable and he starts out with no cash in month one, by the end of month 12, Joe should have $25k X 10 months, or $250k of cash in the bank and $500k in accounts receivable.  At the end of year 2, he should have that original $250k, plus another 12 months of $25k or $300k, for a total of $550k of cash in the bank.  Joe’s accounts receivable, inventory, payables, or long term debt payments didn’t change during this two year payment nor did he take any money out of the business.  Joe also lives where he pays no taxes – the ideal business world.

But Joe’s company is growingCash position changes in a growing business.  Joe’s company is now growing from that $250k a month to $400k a month by the end of year two.  If revenue increases, accounts receivable and inventory increase.  So instead of Joe sitting on $500k of accounts receivable and $250k of inventory as in the story above, he now has $800k of accounts receivable and $400k in inventory, a difference of $750k to $1.2M, or $450k.  If liabilities haven’t increased from month 1 to month 24, Joe would have taken $450k out of cash to fund that growth from the $550k he originally had in story 1, less the $450k he used to fund his company’s growth in accounts receivable and inventory.  So instead of having $550k, he only has $100k in cash in the bank.

Profit does help cash as long as there aren’t other uses for that cash.  Have a great week and balance your cash needs with your projected growth levels.


Dan Lacy

The Business Growth Coach