If you’re looking to start your first small business, there is one thing you need to know more than anything else, the role profit and cash flow will play in your venture.
An Insights West survey found that nearly half of small business owners consider these their main source of stress.
A U.S. Bank study by Jessie Hagan found 82 percent of businesses fail due to cash flow mismanagement.
We don’t want you to become part of that statistic. We want to help you start your small business on the right foot, and increase your chance of success straight out of the gate. To do that, not only do you need to ensure profits, you absolutely must embrace the concept of cash flow management and it’s critical importance to the success of your business.
Understand the Basics of Profit and Cash Flow
First things first: what do we mean when we say “profit” and “cash flow”?
In simple terms, profit is revenue minus your expenses. It is what’s left over when you subtract what it costs to run your business from what you’re charging your customers. Many small business owners, whether new or established, think profit is the true measure of their enterprise’s success. It’s not. Profit is only part of the success story.
“Do not get yourself overly concerned about what your income statement is showing, or even your tax return in some cases,” says small business expert and author Gene Marks. “Be more concerned [about] what your cash flow is.”
What is cash flow then?
It’s the money your business has in its bank account at any given time. It’s the cash inflows and outflows resulting from your day-to-day operations. It’s what comes in from customers paying you, and the money that goes out to pay your bills. It’s what finances your business’s day-to-day operations—paying bills, stocking inventory, subscribing to services, depositing customer payments or compensating your workers.
“It is the lifeblood of your business,” says Denise O’Berry, author of Small Business Cash Flow: Strategies for Making Your Business a Financial Success. “You’ve got to have money coming in before you can put money out. That’s really what cash flow is all about: The in and out of money in your business.”
Think of profit as the theory of your business success, and cash flow as the reality. You can’t pay your electricity bill with profit, only money that’s actually sitting in your bank. Or consider a non-business example. Say your mortgage payment is due on the 15th of the month, and your paycheck gets deposited on the 31st. Now, imagine a month where you’ve had a very expensive first two weeks. Suddenly, your mortgage payment is due, and you don’t have enough money in your checking account to actually pay it. You have a cash flow issue.
Yes, your income statement may show that you earn enough to afford your mortgage. However, on that day your bill is due, you don’t have the cash on hand to pay it. (Hopefully you have a credit card or line of credit to tide you over.) When it comes to your enterprise, there’s no doubt that looking at profit only, even if it paints a pretty picture of your business, is exactly what trips up many small business owners. So how do you avoid being distracted by a pretty profit picture only to trip into the chasm of a cash flow crunch? Good cash flow management is the key.
Learn how to ensure you have the right amount of cash coming in at the right times to meet your the daily needs and obligations of your business – including taxes. Plus, you’ll want to include enough of a buffer to sustain operations in case of an emergency, like equipment breakdown or a plumbing problem.
Get a Solid Financial Education
Understanding the basic terms isn’t enough to ensure you can successfully navigate the tricky waters of cash flow and profit.
You have to do more of what you’re doing right now: educating yourself.
That may sound like obvious advice, but you’d be surprised by how many people don’t do it. “A lot of people go into business without knowing accounting, or actually not really having a good grasp on simple math, so they don’t know the difference between profits and positive cash flow,” says Marks. “If you go in there without knowing those basics of running a business you’re setting yourself up for some pretty big challenges.”
When you have a passion or great idea for a new business, we all know it can be hard to hit the brakes and study up. It may even be tempting to assume that you’ll be able to figure out the financial ins and outs of a small business as you go. You want to realize your dreams, but for your dreams to thrive, you have to protect them. That means making sure you know how to do that. Articles like this—or our guide to forecasting cash flow with spreadsheets—are excellent starting points. But you should also consider investing the time and money to take an online or community college course. Cash flow and profit will come into play daily after you start your new business. Be sure to educate yourself before you’re up and running, so you can benefit from a firm understanding of the role profit and cash flow will play. And if you are up and still running, then it’s not too late, study up!
Use the (Software) Tools That Are Available to You
Another key way to navigate the ins and outs of profit and cash flow is knowing how to keep an eye on them. You want to be sure that, at any given moment, you know exactly how your business is doing: how much money you’ve invoiced, how much you’ve received, and if it’s enough to pay your bills on time.
Again, you’d be surprised how many folks don’t help themselves by keeping an eye out for that. A survey by Wasp Barcode Technologies found that over half of small business owners do not track their assets. There’s no excuse for that, especially when resources like accounting software programs—such as QuickBooks, Xero, FreshBooks, Wave, Sage, and Zoho—exist to empower small business people to grasp their financial situations.
Use the tools available to you (including our own cash flow calculator) and be sure to pick ones that are comprehensive as possible – capable of giving you both the big picture and the daily update of your finances.
All that being said, don’t let those programs tempt you into thinking you don’t need to educate yourself. Software, however valuable, is no replacement for financial know-how.
“Like any tool, they’ve got to be put in the hands of somebody who knows what to do with them,” Marks says. “It still does not relieve you of your responsibility to get an education in accounting and cash flow if you’re going to run a business.”
Never Forget About Uncle Sam
If a new small business owner doesn’t do their homework, there is a season every year, when they will see the dramatic difference between profit and cash flow: tax time.
That’s when many discover it’s possible to be profitable but cash poor at the same time. And that’s because they mismanaged their cash flow by, for example, overspending on inventory, or failing to collect money from their customers.
“The thing that I see over and over again is people in a business that is actually making a profit, and when it comes time to pay taxes, and they say, well, ‘How can I owe taxes? Because I don’t have any money,'” says Caroline Grimm, author of Stop the Cash Flow Roller Coaster.
For every dollar of profit, you get taxed. If you don’t put that money aside and protect it (ideally, in a dedicated bank account you never touch), you can easily find yourself not having the money you need when Uncle Sam holds his hand out. In fact, a 2014 GoDaddy survey found that 32 percent of small businesses fail to put money aside for tax time, and 12 percent don’t even have an idea of how much they’ll owe.
That’s another reason why understanding cash flow is so important: you’ll know that just because your business shows it made a certain amount of money on paper, that doesn’t mean you actually have it on hand.
Know Which Customers to Pick for Your Business
Once you understand the significance of cash flow to your business, something becomes clear very quickly. “One of the keys to being successful in business and having a healthy cash flow: targeting the right customer,” says O’Berry.
If you don’t get paid, you have no cash to run your business. Yes, better invoicing can improve your cash flow, but ensuring you have ideal customers is especially important.
That can mean doing credit checks first, making them agree to pay all invoices in three days, or using PayPal payments. Do whatever you need to do in order to ensure your cash flow is protected.
What if a customer resists, and wants the standard “Invoice after 30 days. Pay after another 30 days” arrangement? Consider adding a premium so you get more money when they do finally pay.
Or you could entice them by doing the opposite and offer a discount for quicker payments. It may lose you a little bit of money, but that can be worth what you get in exchange: reliability.
Cultivating a customer base whose payments you can depend on will do wonders for your cash flow, your business, and your life. “From the beginning, you want to set a precedent and say, ‘This is how it’s going to be.’ It will save you so much money and heartache and stress,” says Michelle Dunn, author of The Guide to Getting Paid.
Don’t Be Afraid to Learn From Failure
It’s a hard truth that even if you manage all of the above, once you start your small business, you may face times when cash flow will be tight – possibly because you made a mistake. But know this: that’s okay. A survey by Fifth Third Bank found that 4 out of 10 small business owners didn’t have enough cash to meet their business goals, so you’re not alone.
That’s not all.
“It’s at that moment [when money is tight] that you suddenly realize the true importance of bringing cash in,” says Marks. “Sometimes you’ve just got to be living it to really learn it, and that’s how the lesson sinks in.” That can be incredibly valuable. What’s more, that experience can teach you what you can’t learn practically: the greater importance of cash flow.
“What your cash flow is, is the story and health of your business. It can tell you over time what’s successful, what’s not so successful,” says O’Berry. Understanding profit and cash flow then allows you to control the story of your business. Even better, it gives you a better chance of writing a happy ending for it.
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