ABF Signals – Cash is King
I’ve often heard the phrase ‘Cash is King’ but what does it mean for me?
This covers a number of scenarios but the one you are interested in is income of a business, the whole quote being: “Turnover is vanity, profit is sanity but cash is king [or reality]”
OK, so break that up for me, why is turnover just vanity?
Businesses can often chase turnover on the basis that the more business that they do, then the “better” the business performance will be, or at least appear to be. However, to decide whether the increase in turnover is worthwhile, you need to consider how this increase is achieved. Did you have to reduce the sale price, or increase costs at all? If so, consider the impact on your net profit and whether there has been a net benefit to the increase in sales.
Give me an example please . . .
If you are currently selling 10,000 units with a £5 margin but could increase sales to 15,000 by reducing margin to £3, then your gross profit has fallen from £50,000 to £45,000. You may have increased your sales by 50% but this has damaged your profit. If your margin was cut to £4, then the gross profit is now £60,000 but, for example, did you need to take on a new part-time employee to achieve these sales? So long as this cost was less than £10,000 then you are ok, but if higher you are in deficit.
What about profit?
It’s probably easiest to look at profit and cash together and – if you don’t mind a few more numbers – to illustrate with another example.
Let’s say that you sold services of £100,000 which cost you £75,000 to provide, a nice straightforward profit of £25,000.
However, you won’t be paid the £100,000 for 30 days but need to pay out the £75,000 cost immediately – you now have a cash shortfall of £75,000 even though you have made a profit of £25,000, a situation that many will be all too familiar with.
And presumably that carries on getting worse each month?
Well the good news is that if your sales remain static, the situation doesn’t get worse because next month you will receive the original £100,000 income at the same time that you need to pay out the next £75,000 for this month’s costs.
At the end of month 2 therefore, you have made £200,000 sales, for which you have received £100,000 cash, another £100,000 to come in 30 days, and paid out £150,000 costs. So profit of £50,000 and negative cash flow reduced from £75,000 to £50,000.
If on the other hand, your sales continue to grow each month, then it is possible that your cash flow continues to get worse.
So how can I overcome this?
Essentially you need to make sure that you have enough liquidity to cover the situation, either cash or the ability to draw on some sort of facility to pay the bills. Invoice Finance could work really well here. Effectively an Invoice Finance company lends you the outstanding value of a large part of your invoices (typically 80%) when you issue them. You receive the balance when the invoice is finally paid and the lender is repaid from the invoice payment, plus interest. One way of accessing Invoice Finance companies is via our Funder Finder
Alternatively you could always negotiate quicker payment from your customers and / or later payment to your suppliers but never lose sight of the need for cash. If you’re purchasing a vehicle for your business it’s not always the best option to pay cash just because you currently have it available. It might be worth considering Asset Finance to help make that purchase and keeping some of that cash for the sort of situation described here.
And that’s why cash is more important than profit?
In the short term, arguably so. You will always need the ability to pay your bills as they fall due because that’s the reality of day-to-day trading.
That said, it is of course good to achieve profit, not least because profit eventually leads to cash and it certainly leads to an improving balance sheet . . .