Stewart and Smith Advisory Enriching lives through building better businesses

The Importance of Cash

The Importance of Cash

To quote Alan Miltz “revenue is vanity, profit is sanity and cash is king”.

When we work with business owners and managers, we find that they do not understand the true financial position of their business.   Whilst some owners look at their profit and loss, they rarely review their balance sheets and never look at their cash flow statement.

I have worked with owners who take on projects at margins or payment terms that will cripple them – it is not sustainable even in the short term but they want the revenue growth ‘at all costs’, not understanding the lack of profit margin doesn’t make up for the greater volumes of revenue.  Bad payment terms without understanding your cashflow cycle will strip your bank balance very quickly.   You will end up losing more money than your P&L shows you.   Taking on loss leading projects or projects with unrealistic payment terms is not sustainable and most definitely will lead to business failures – always.

If the owners or managers are looking at the profit and loss and getting excited about the results, they need to also look at the balance sheet, the aged debtors and creditors and the cash flow statement.

How can you make a massive profit but have an empty bank account and large amounts of creditors yet to pay?   Usually these are ATO payments (GST, BAS, PAYG, Payroll Tax, Super) and the ATO is not known for their patience in repayment.  Some tax obligations, if not paid in a timely manner, have personal Director’s obligations attached – never a smart approach to jump out of the Corporate veil into personal Director territory.

We had an investor come to us as he couldn’t understand why the company that he had loaned $450,000 of funds to seven months ago was not able to repay his loan and was going broke – what happened, as the business was generating revenue?   A review of the Balance Sheet, P&L and Cashflow statement showed that the business had spent money buying inventory that they sold for low contribution margins as well as spending money on fixed assets and large advertising/marketing budgets.   A loss of $400k in four months and out of cash in seven months.

What does this all mean?

Revenue growth doesn’t necessarily mean your business is healthy – so if you are looking at revenue without looking at the margin and the cost of generating that revenue, you don’t have the full picture.  Not all revenue is equal – here we need to think about contribution margin – bear with me as it’s not as complicated as you think.  Contribution margin or $$ contribution per unit (or per project or client) is the selling price per unit/project/client minus the variable cost per unit/project/client.   Contribution represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.   Revenue without understanding contribution margin will leave you with not enough money to cover fixed costs and deliver a profit.

Profit is a better indicator of business success however profit on a P&L needs to be understood.   A P&L provides a picture of your business at a ‘point in time’ i.e. end of month or year to date.   Your profit could include revenue for which you are yet to be paid, it may also include accounting adjustments some of which are already paid but some of which are yet to be paid.   To understand what some of these adjustments are you will need to look at the connection with the balance sheet as well as the cash flow statement.

Cash is KING.   Business owners need to understand:

  1. The working capital cycle – if you are efficient with your cash then you are aiming to have a shorter cash cycle in days. Where you have timing issues, change your business model, terms of trade or seek short term financing.
  2. Review the Cashflow Statement each month as well as the P&L and Balance Sheet. Understanding what the OPERATING CASHFLOW is and setting targets for minimum cash balances is essential.    A cash flow statement shows how the changes in balance sheet accounts and income affect cash and breaks the analysis down into operating, investing and financing activities.
  3. At the time you create your budget, ensure that it is converted to a cashflow forecast.
  4. Know your cashflow break-even level of sales.
  5. Regularly update your cashflow forecast to understand your cash burn as well as future cashflow requirements – you do not want to run out of cash and if your business needs additional financing, this will take time to organise so allow yourself enough runway.

Revenue is vanity, Profit is sanity and Cash is king   A. Miltz