It's always funny to listen to new entrepreneurs talk about how few sales they need to make a ton of money. If you haven't been through it before, you don't realize how much cash you have to reinvest in your business, and how hard it can be to collect everything you are owed. That is why rapid growth sometimes kills startups – because business owners don't understand the difference between income and cash flow. Most of you probably know this, so feel free to move on to the next post. But for those of you new to owning a business and sans accounting knowledge, use this as a starting point to research and understand more.
What is Cash Flow?
In accounting terms, Cash Flow is the amount of money that a business receives and spends during a particular period of time. It's not sales made on credit. It's money you have collected and can really spend. A look at the cash flow statement can provide insight on a company's financial position and its ability to remain solvent in the short term.
What is Net Income?
To put it simply, Net Income (also called bottom line / earnings) refers to the profit or the loss that remains with a business or an entrepreneur after all the cost and expenses are subtracted from the total revenue.
The reason why there is a conflict between net income and cash flow is that the income statement is updated with any sales made or revenues earned as soon as the deal is done. However, payments for such sales may be actually received much later. Hence, though the net income shows profits and the entrepreneur in reality has made money, it is not yet available as cash flow and cannot be spent.
For example, say you make umbrellas. You invest 5K of your own money to buy the parts and build the umbrellas. You sell the umbrellas to a retailer for 7K, so you made 2K, right? Well, the retailer probably wants 30 days to pay you. In the meantime, you have no umbrellas to sell, no parts to make new umbrellas, and no cash to buy parts until the retailer pays you.** But technically, you have 2K in profit. See the problem?
This is why too much growth can also hurt businesses in situations where the income statement / accounts receivable grows much faster than the cash flow available at a certain point in time. Such an imbalance in the net income and cash flow means that though as an entrepreneur, you are generating profits from your business, still you don't have enough cash to spend on labor and materials.
Money has been made but it hasn't been collected yet.
Falling in to a situation like this is troubling and often frustrating. Here are some ways by which you can try to fix it –
1) Keep an Eye on Your Cash Flow: As an entrepreneur, you must get into the habit of watching your cash flow to understand the actual amount of money available to the business at a particular point in time. In the event that you feel the cash flow level is running lower than it should, this is the right time to seek financing to make up for the shortage.
2) Implement Payment Policies that increase cash flow: To improve your financial stability and maintain solvency, you must consider revising your payment policies. Ask for up front payments and introduce schemes that offer discounts for full payment or pre-payment. This will enable you to generate cash into your business and handle your finances well.
3) Be Diligent at collections: One of the most important aspects of running a successful business is to tighten up your operations, especially collections. Sure, you want to be a nice guy. You want to cut the customer some slack. But this isn't the place for it. If you want to help out a fellow business owner, find a way to do it that doesn't impede your own cash flow.
You've probably heard the saying "cash is king." Now you know what it means and why so many business owners take it to heart. Don't fall victim to your sales success by running out of cash.
**this is why you want to buy your parts on credit if you can, but many companies won't issue credit to new businesses unless the owner signs a personal guarantee