17 Aug How Focusing On Profits Can Harm Your Startup
Balancing your finances can be a super-sized task for just about any business owner. But knowing what to focus on can save you valuable time and money.
The first step in evaluating your business’ finances is to check your cash flow. While it might be tempting to take a peek at your profits first, those won’t be the most helpful numbers. Why is cash flow important?
When it comes down to it, being a profitable business does not inherently mean that your startup is in the financial safe zone. And while your profits do have an important role, being able to manage your business’ cash flow will likely be the determining factor in whether your company does well. In fact, poor cash management is responsible for a large number of companies failing. Here are some things to keep in mind, so your business stays out of trouble.
What is Profit?
To start things off, you should note that while both cash flow and profitability measure how well a business is doing financially, they are not the same thing. Being profitable does not guarantee that your startup will be able to pay its bills. Furthermore, even businesses that are able to pay their bills may not actually be profitable.
Your profits will show your financial gain, which is the difference between the amount earned and how much you’ve spent.
To put it simply, revenue — expenses = profit
Profit is typically presented on an income statement or profit and loss statement (P&L) as net income.
For example, if you have a software subscription startup that has 200 customers and each month, you bill $100 to all of them, you are generating $20,000 in revenue. Let’s say, to run the business, you have server costs and other overhead, which total $4,000. With this example, your profit would be $16,000.
Following the equation above, we can input those values and also find the profit: $20,000 — $4,000 = $16,000.
In this example, since you still have $16,000 after expenses, it means that your business is profitable. However, there’s no indication of whether payment was collected from all 200 customers, nor does this figure take into account any unforeseen expenses. Will this profit be enough to pay all of your upcoming bills? What about taxes?
This is the problem with profitability. It provides information on whether a business is earning or losing money, but it leaves out some very important information. Solely focusing on profit isn’t a reliable way to gauge your company’s financial situation.
What is Cash Flow?
To understand the whole story, you need to know more than just how much you’ve earned; you need to take a look at the money coming in and out of the company—your cash flow.
Cash flow is essentially a detailed summary of where your cash is going and when. To go back to our previous example, looking at cash flow would tell us when all $20,000 in revenue would be collected, and when exactly we will pay out the $4,000 in expenses.
When analyzing cash flow, you’re essentially forecasting or estimating when you will collect revenue and when you will pay your bills.
To forecast cash flows, you only need to do these three things:
1. Determine your current bank balance
2. Forecast your revenue
3. Forecast your expenses
If, for example, you wanted to forecast your cash flow for August, your projection would look something like this:
Starting bank balance + revenue collected — expenses paid = ending bank balance
To continue from our previous example, if you estimate that you will be able to collect payment from 55 customers in August, and the business will pay out $2,500 in expenses, your cash flow forecast would look like this:
$15,000 + $5,500 – $2,500 = $18,000.
This tells us that you started the month with $15,000 in your bank account, and after collecting from customers and paying your obligations, you’re planning on ending August with $18,000 in the bank.
That’s a net gain of $3,000. As you can see, this is a lot less than the $16,000 in profit that will show on the income statement for August.
There are numerous paid tools to help you forecast your cash flows, but sometimes a simple spreadsheet will do the trick.
Some businesses forecast their cash flow on a monthly basis, while others need to do this week-by-week or even daily. Choose whichever period makes the most sense for your startup. If you’re tight on funds, then a shorter time period will be most useful. When projecting, it’s often best to forecast only 2-3 months at a time, as your estimates become less accurate the further out you’re forecasting.
Why is Cash flow Important?
While both cash flow and profitability complement each other, you’ll notice that cash flow provides more information and, therefore, can be the most beneficial way to analyze your business’ finances. Forecasting your cash flow will help provide up-to-date information on your ability to meet your financial obligations, while giving you the peace of mind to make confident financial decisions. Sounds like a superpower, right?
Here are some other reasons you should pay attention to your cash flow:
1. Cash Flow Helps You See The Whole Picture
Although the idea of profits can seem exciting when you’re looking at your finances, there are good reasons to look beyond them. Think of it this way: Like many startups, you may have a loan that needs to be repaid. The interest may show up on your income statements, but the loan repayment may not. If you’re unprepared for these payments, they can wreak havoc on your finances. Save yourself the stress, and the last minute scramble, by including them in your cash flow projections ahead of time.
2. High Profits Don’t Equal Money In The Bank:
If you’re solely depending on the numbers surrounding profitability, you won’t be able to make smart financial decisions. Even with profits, your company can still not be able to pay its bills. In order to ensure that you meet all of your financial obligations, such as paying your employees, paying taxes, and purchasing supplies or inventory, make sure you look beyond transaction histories and accounting profits and focus on your cash flow.
3. Profitability Tells You Nothing About Day-To-Day Operations:
Profitability merely shows you the numbers, not whether payments have been collected for transactions, and there are a variety of reasons that the payments can be delayed. If you’re only looking at your profits, you may not know when your numbers will translate to actual cash, or whether these payments will help you pay your employees this month.
Make sure to keep an eye on your cash flow so that you have a proper idea of how much money you actually have coming in and out of your accounts so you don’t end up in a financial tangle.
4. Profits Can’t Predict The Future
When it comes down to it, relying solely on your profit numbers won’t give you a reliable or accurate idea of which direction to take your business in. Having up to date information is essential to keeping your company on target, and this means continually assessing where your cash is going and coming from.
A tip for keeping an eye on your cash flow is to focus on the data you’re given. Remember: cash flow is all about the factual – not the hypothetical. Consistently gauging your data will help you plan for future spending, know when to bring new employees on, and keep your business from getting off track.
5. Cash Flow Will Help You Prep For Tax Season
Yes, it’s true. The part of running a business that nobody likes to talk about, but everyone has to handle. Taxes. By monitoring your cash flow, you can avoid problems such as being unprepared for unforeseen expenses or overspending. Forecasting your expenses will help plan for tax season and help ensure that you have enough cash to pay your next tax bill.
One of the greatest stressors for entrepreneurs is facing the uncertainty of whether their business will be successful and financially stable. Save yourself the added stress to your already hectic life by taking note of your cash flow.
How to Properly Manage Cash Flow
Proper cash flow management isn’t solely about being able to accurately forecast your revenue and expenses, it is also about managing things such as the collection of money that’s owed to your company (aka accounts receivable), and even your inventory.
Here are four tips for keeping your cash flow management on track:
1. Clean Shop:
Make sure your billing procedures are as effective as they can be. Reduce shipping and invoicing time and make sure your policies for credit and collections are lined up.
Offering your customers discounts for making early payments is mutually beneficial to both you and your clients. You receive payments early and they receive a discount for parting with the cash. If you charge monthly fees, consider introducing an annual plan, with a discount for paying upfront. If you have enterprise customers or any customers that you invoice, and you find that you’re consistently receiving late payments, you may want to consider charging some kind of fee. Both of these policies keep you ahead of the game, and will ensure that your finances stay on track. In our above example, only 55 of the 200 customers actually paid. This would certainly be an opportunity to provide early-pay incentives.
3. Collect A Portion of Fees Upfront:
Consider asking your clients to pay a portion of their fees upfront. Use your best judgment for what this should be, whether it’s 10, 15, or 20 percent of their costs.
4. Keep Track of Inventory:
If you’re selling a physical product, being aware of what you have to offer allows you to know when it’s time to dispose of obsolete inventory, or even offer it at a reduced price. This will strengthen your cash flow and help your business to stay relevant.
Not only can monitoring your cash flow give you insight that will allow for better utilization of the cash involved in your business, but it can also allow you to plan for generating additional funds from within your company, and provide helpful insight to the future needs that you will want to pinpoint ahead of time.
Additionally, you’ll want to take into consideration the level of liabilities, including credit cards and loans, before declaring your businesses profitability. As with anything, there isn’t only one answer to keeping your business on track, but managing your finances and paying attention to the benefits and knowing what they are is a good place to start.
Ready to prepare your own cash flow forecast for your business? Download this free cash flow template to get started!