Profit or Cash - which is more important?

Jim Stockton, Senior Lecturer in Finance at the Warrington School of Management (University of Chester), discusses profitability and liquidity planning – essential elements for every business to succeed!

Introduction

There are many reasons why these failures occur-some relate to the lack of a coherent business strategy, some to the absence of a focussed market research but many are simply due to the absence of some rudimentary financial planning, or to be blunter, basic budgeting. This brief article seeks to point out some fundamentals on this often neglected skill or to quote Monty Python the “bleedin obvious”!

Budgeting

Budgets are generally regarded as having at least five areas of usefulness:-

• Budgets tend to promote forward thinking and the identification of short term problems
• Budgets can help, in larger businesses to co-ordinate activity and ensure a common understanding exits on priorities-for example there is little point in the sales team aiming to deliver optimistic targets if the production team have a different aim in mind
• Budgets can motivate managers and staff to improve performance if “stretch “ goals are set
• Budgets can help control a business-simply put does actual performance, measured monthly, compare favourably or adversely with the budget?
• Budgets can also act as a means to authorise spending within a business

The purpose of this article is to concentrate on the difference between profit and cash flow or, put another way, highlight the fact that profitability AND liquidity are opposite sides of the same coin when it comes to business survival. Business may fail through lack of profitability but its running out of cash that actually sends them to the wall. Indeed it is entirely possible for a profitable business to go bust by failing to pro-actively manage cash flow (known as overtrading)

Profitability

Let’s consider some basics-business has to generate profit in the medium to long term-after all, in our capitalist society, that is what it is all about-why take the risk otherwise? Business entrepreneurs see an opportunity in the market place to launch a product or service and to do so in a way that will generate a profit possibly with an idea or expertise that others will find difficult to copy. A business plan can be developed around this which should be capable of being expressed in financial terms-in other words- a profit forecast based on the sales compared to the cost of those sales. All pretty straightforward so far hopefully.    This forecast or budget can and should be expressed over a reasonable time scale and should be as detailed as possible especially in the early days of the business-certainly for the coming year (broken down into months) and hopefully for another two years after that in order to give a reasonable perspective on the future of the business.. Let’s assume our small business compiles a profit forecast and that it looks reasonable-losses can be incurred in the early months as long as the longer term position indicates future profitability on a sustained basis. This profit projection can be enhanced by compiling a forecast balance sheet which will indicate:-

• The assets the business will own
• The liabilities it will generate
• The impact on the owners initial and subsequent investment

It is important at this stage to differentiate between the long term (investment in fixed assets such as premises, machinery and vehicles) and shorter term assets such as stock, debtors and free cash). Equally a distinction needs to be made between short term financing obtained by trade credit from suppliers and an authorised bank overdraft and longer term funding via a formal bank loan for example.

Cash flow/liquidity

It’s at this point where the cash flow forecast becomes important-even vital. Our profit forecast can and should indicate business profitability based on the assumptions made by the owner of the business. However the next question to be asked is how does this affect cash flow going forwards? Just because the profit forecast is positive does not mean that the business will generate a positive cash flow and enable the business to meet its short term liabilities which includes those nice people from HM Revenue and Customs as well as suppliers to the business. The profit forecasts need to be converted into cash flow forecasts that take account of:-

• Credit terms to be granted to customers
• Credit terms obtained from suppliers
• Stock holding levels to prevent stock outs but avoid overstocking
• Investment in longer terms business assets
• Use of any agreed overdraft facility
• Longer term financing facilities

Plugging this information into our cash flow forecast should reveal any problem areas regarding whether the business will run out of money or need to increase any of its financing sources i.e. additional overdraft facilities, a longer term loan arrangement or increased investment in the business from the owner. At this point, it should become clear whether the business has a chance of financial survival or whether a complete rethink is required concerning the business assumptions built into the profit forecasts. Sometimes numerous iterations are required (know rather grandly as “sensitivity analysis”) in order to arrive at a business plan that meets the business owners’ aspirations but is also grounded in commercial reality as far as the generation of cash is concerned.

Summary

This article is necessarily brief and skips conveniently over numerous issues in order to deliver a fundamental point-(remember Monty Python above?). Business must financially plan to in order to succeed and that planning must involve profit planning and liquidity planning. One without the other is a business disaster waiting to happen.  

  Jim Stockton, Senior Lecturer in Finance at the Warrington School of Management (University of Chester)    



    

Straightforward & quite useful read on starting a business RT @InCheshireMag: Profit or cash? Which is more important http://t.co/nHSnOqkj7I
— Matt@NooksYard (@NooksYardCider) April 28, 2014