By Ruth King
One of my first clients was a florist. She got her financial statements at the end of each month, looked at the bottom line and saw that she had a profit. She then put the statements in the drawer and forgot about them. She became puzzled when she could not pay her bills but her statements showed that she was profitable. The florist was making a mistake that many business owners do…equating profits with cash.
For operational purposes, most companies are set up on an accrual basis which means that you record a sale when you make it; not when the cash is collected. Likewise, you record an expense when the bill arrives, whether or not you’ve paid it. You have accounts receivable and accounts payable. You should always have more accounts receivable plus cash than accounts payable.
On an accrual basis you can match revenues with expenses incurred producing those revenues to ensure your products are profitable.
On a cash basis you will almost always show a profit unless you bounce checks! You won’t pay a bill until you have cash to pay it with. This doesn’t mean that you have profitable sales.
For companies on an accrual basis when you look at the bottom of your financial statement and see a positive number it only means that you earned a profit. The number at the bottom of the statement does not represent cash. It is simply the dollar amount of the profit that you earned for that period of time.
You must convert that profit into cash. This means that you have to collect the money for your work, pay your expenses against the job, and then have cash left over. Most companies have more than one job per month. So, your accounting program adds all of the revenues from all jobs and subtracts all of the expenses from all jobs (you can also get an individual job cost report). On your balance sheet it shows you the cash you have and the receivables you have as a result of the jobs. You must be aware of and collect the receivables within a period of time so that you can pay your employees and other bills.
So, don’t feel too secure when you see a profit shown on your profit and loss statement. Look closely at your accounts receivables to make sure you collect for the profitable work that you did.
Ruth King is known globally as the “Profitability Master,” and is a a thought leader in entrepreneurship and business. Her books have been recognized as among the greatest in numerous industries. Learn more about all her business activities here.