The Profit Illusion
This is the sixth 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 about whatever you want to do.
Sam owns a small manufacturing company. He is profitable but has no money and in a constant cash flow crisis. He called me and asked “how is this possible”?
Sam was doing just about everything right. He had a budget for the year, a decent profit target of 7.5% of revenue (consistent with past years), wasn’t on a growth trend and didn’t spend any money on capital improvements. He was completely frustrated with not building the cash reserves he so desperately wanted.
My analysis offered this review for Sam.
- He was profitable – no doubt about it. In fact, a little stronger than he thought, nearly 8% on revenue of $5M.
- He was controlling growth of inventory and managing accounts receivable.
- His line of credit was paid off and long term debt wasn’t a major challenge.
- He had pretty consistent revenue, varying only 3% quarter to quarter and always hitting his year end growth target of 4%.
Why didn’t Sam have any money? Sam had a high life style and was taking nearly all of the profit out of the business each year through distributions which didn’t hit the profit and loss statement, and the activity only showed up on the balance sheet. Although profits will increase cash in the business as well as improve equity, in Sam’s company, equity didn’t change much from one year to the next. Sam couldn’t grow cash in his company because he was sucking it all out through distributions.
Most businesses will return 30% – 50% ROI year after year (profit divided by business equity), but only if there is adequate cash in the business to grow. One needs to measure the ROI on money taken out of the business as well as money left in to see which has the highest yield.
The Business Growth Coach