Profits vs. Cashflow – Do you really know the difference?

In my office I have 2 young, inexperienced girls who help me. They both have wonderful personalities and great phone voices and, though they’re not perfect, they seem passionate about their jobs and eager to learn. One girl’s responsibility is to help me grow the business, the other is to help me cut expenses… At this point I’m still trying to determine if I’m better off employing people who I can train from the ground up, as The E-Myth Revisited suggests, or if I should hire the best people and pay accordingly, as many business owners suggest.

However cutting expenses isn’t as “straight-forward” as one would expect. If you had to explain and train a 19 year old with no experience on how to manage the payables, purchasing, inventory and cashflow for a business employing 13 people what would you teach them? How would you teach it?

These are the questions she needs to consider every day:

1. How can we improve Profits?
2. How can we improve Cashflow?

So let’s explain the difference between profits and cashflow first.

1. Profits – Profits are an income statement or financial and tax reporting number. They don’t have a direct influence on if you can pay your bills or when. This number simply tells us if you sold more then you spent.
2. Cashflow – This is money or cash you have available to spend. In other words, cash in the bank.

A quick example to illustrate the stark difference between profits and cashflow and why both need to be addressed is this: If I can order 100 widgets at a 10% discount and I ultimately sell all 100 widgets, then I just increased my profits 10% by cutting expenses. However if I order 100 widgets at a 10% discount and it takes me a year to sell them so I didn’t have the cash to pay the bill right away, the late charges and finance charges may out weigh the 10% discount. Or let’s say they only gave us a 3% discount, I could have put that money in a money market fund for the next year at a higher interest rate then 3% and been better off.

OK, so how do we systematize and simplify this concept? We created a spreadsheet listing all of our vendors along with the following columns with information: Vendor, Terms, Discount Terms (i.e if it’s due in 30 days but we pay the bill in 10 will we get a discount?), Late Fees, Finance Charges, Grace Period, Finance Policy.

That simple spreadsheet tells her, me, the person who replaces her if she quits, my business partner or anyone else who looks at it exactly who we need to pay and when. In other words, if cash is tight, we simply reference the spreadsheet to determine which bill we pay first and which ones we can pay late and with the “Finance Policy” we can even estimate who may credit off finance charges if we call and negotiate.

The “Terms” tell us about our cashflow options and the “Late fees”, “Finance Charges” and “Discount Terms” let us know how the vendors’ policies will affect our profits. It’s simple and straightforward, however it does take some work to collect all of this information from all of your vendors.

Keep in mind, your vendor may tell you something that experience tells you is not true. For instance, MOST billing systems where you are sent an invoice have a set term in days, however they don’t actually apply late charges until the end of the month. So you may receive an invoice on 10/25 that says Net 15. The invoice says it’s due 11/9 and that late invoices will accrue a finance charge of 1.5% per month. If you call and ask the vendor, they’ll tell you it’s due 11/9. However what that generally means is as long as you pay the bill before that company “closes their billing month” (which could vary from the 25th to the 31st of the month) you won’t be assessed any finance charges. In essence that mean the bill isn’t due until the end of the month. 🙂  In our spreadsheet we know which customers to pay exactly on the due date and which to pay before the end of the month because of the “Grace Period” field.

With QuickBooks Pro 2009
this process becomes even easier. You can setup custom terms along with applicable discounts so that when you put in the bill, Quickbooks automatically knows, and applies, your “Early Payment” discounts for the vendors who offer them. This is possible whether you receive discounts by paying exactly within 10 days from invoice date or if you just have to pay before the 10th day after the month-end in which you recieved the invoice. The custom terms in Quickbooks is quite powerful. It’s main limitation, and the reason for the spreadsheet, is you need to know the “Grace Period”, if any, as well as the “Late Charges”, “Finance Charges” and “Financial Policy”. You could probably put that information in the notes field on the vendor’s account but quickly referencing the spreadsheet seems to be easier.

In addition to the information and concepts I need to teach to my impressionable payables person, there are a few concepts that just my accountant and I need to understand. Those are the expenses I must depreciate and the goodwill I can amortize. Depreciation can either help with profits and hurt cashflow or hurt profits and help with cashflow. First off, helping or hurting your profits depends on whether you’re talking with your banker or the tax man. If you’re talking with your banker you obviously want to show lots of profit however with the tax man you want to show very little. Granted, we need to be honest, upfront, and ethical with both if we want the best for ourselves and business. Your banker will often look at EBITDA so that your non-cash expenses won’t hurt the “profits” they consider, but they’ll also look at your cashflow statement. Depreciation is usually a negative against your cashflow initially and a positive near the end of a product’s depreciable life. For instance, you may depreciate a computer over a number of years, however you need to pay for it all upfront. Since you have to pay for it immediately your cashflow is hurt. Yet, it’s now paid for so in a year the bills are all paid, but you can still take the depreciation expense on your books to minimize your profits and which helps minimize your tax burden. As a general rule, you expense everything immediately and forget about depreciation! Why? Because taking the immediate expense will help your cashflow by decreasing the taxes you’ll have to pay on your profit. There are exceptions…

Without going into a lengthy explanation of amortization, the rules are relatively the same as depreciation. The primary difference being that amortization NEVER effects cashflow. Amortization is simply an accounting number that has no bearing on your actual cash investment. I know accountants will disagree with me on this because they say it represents the difference between what you’ve bought something for and what it’s worth so your amortization deduction is equal to the cash you paid out of pocket. This is only true if you used your own money to buy the business. But why would you do that when 65% of businesses are sold with some sort of vendor financing?

For some more specific ideas on the ways your payables person should be improving cashflow check out my other blog.

To your success, Bryan

If you’d like a copy of the spreadsheet email or comment.