Profits, but No Cash!

On more than one occasion I have had a business owner meeting me for an initial engagement explaining to me one of their major concerns described usually as follows:

“I simply do not understand what is going on.  My company consistently maintains good profit margins; however, I struggle with having adequate cash balances and maintaining positive cash flow.  If profits are high, why does my company not have or generate cash?”

Before getting into the answers of this question, I first want to compliment the business owner for a couple of positives that are obvious by their question.

• If there are differences in the profits of the business and the cash position, this indicates that the business is using the accrual method of accounting for their Profit/loss and Balance sheet statements.  This is exactly the correct method of measuring the financial condition of the business because the accrual method accurately matches sales and expenses in the same time period.  Only in this way can a company owner manage his business using his financial statements as a valuable tool.
• If profits are positive, adequate, and growing, this is an indicator that the company’s products or services are priced properly or the costs of running the business is being controlled properly or there is a combination of both.

Now let’s get back to answering the original question which is in essence, if profits are there, why is there no cash?  There is any number of reasons why the cash does not follow the profits.  The answer usually revolves around the following issues or a combination of several of them.

• The profit measurements are inaccurate.  A business owner may operate under the illusion that his company is profitable when in fact that is not the case.  It can be due to an inventory balance that does not match the physical count, bank balances that have not been reconciled, sales recorded before actual service is performed or products shipped.  It is imperative that the owner have total confidence in the accuracy of the basic financial statements.
• Cash is tied up in accounts receivable and inventory.  Large past due accounts receivable can tie up chunks of needed cash.  Business owners must ensure that receivables are reviewed weekly at a minimum, collection calls are made timely, and adequate credit checks are performed on new customers.  Also, inventory balances should be continually monitored to maintain only those levels needed to service the customer timely.  Old inventory should be written off and scrapped and physical counts continually checked with balances recorded on the financial statements.
• Accounts payable are not managed properly.  Pay according to terms agreed to and not a day before, unless cash discounts are negotiated.  I know there are occasional exceptions but paying invoices too early can seriously affect positive cash flow.
• The bank line of credit is too low.  This is particularly true for a rapidly growing business.  Adequate credit lines should be maintained by proper planning meaning timely cash flow forecasting and budgeting.
• Fraud is being committed.  Do not dismiss this last point.  If there are no proper internal controls in place, a company is ripe for internal fraud.

The goal is high and growing profits and a strong, solid cash position.  This ensures high company value in a competitive market.