Many small business owners think that high profit translate into a greater amount of cash at their disposal. However, this is not always true. Your firm could be reporting large profits but may be short of cash.
How can this happen? Shouldn’t your profits and cash balance rise simultaneously?
Unfortunately, that’s not the way it works. Higher net income or net profits do not necessarily mean more cash. Let’s understand why this happens.
How can your business be profitable, but be cash poor?
A simple example will illustrate this point. Say, your company gets a $10,000 order. You supply the goods and raise an invoice on the customer. However, the sale is on credit, and the client will pay only after 60 days. Let’s assume that your profit margin is 30%. So, you have increased your net income by $3,000 (30% of $10,000), but at the same time, have depleted your cash balance by $10,000.
In other words, your net income has increased, but your cash balance has fallen.
Here’s another example that shows why you shouldn’t equate net profits with cash availability. Your business gets an opportunity to buy inventory at a discounted price. But the supplier insists that you pay cash in advance. If you decide to go ahead with the transaction, your cash balance will fall when you make the payment. There is no immediate effect on your firm’s profit.
Let’s summarize these two examples:
|Transaction||Impact on cash balance||Impact on net profit|
|Sale on credit terms||No impact||Net profit rises|
|Purchase of inventory by paying cash in advance||Cash balance goes down||No impact|
What can a small business do to boost its cash balance? One precaution that you could take is to reduce sales to customers to whom you have to offer longer payment terms. However, if there is an industry practice to sell on credit, you must learn how to manage your accounts receivable effectively.
Learn more about the differences between these two concepts by reading Cash Flow vs. Profit. This will help you learn how you can improve your company’s cash balance.
Understanding your income statement, cash flow statement, and balance sheet
To manage your cash balance effectively, it’s also important to familiarize yourself with the three major financial statements any business should have in place.
Do you know how your accounting system works? Although it isn’t necessary to be an expert, there are tremendous benefits to be gained from acquiring a basic knowledge of accounting rules and principles. The first step that you must take is to understand each of the following financial statements:
Income statement: This provides you with your sales revenues, costs, and your net income. It is always prepared for a specific period. So, the income statement could be for a month, a quarter, six months, or a full year.
Remember that the income statement calculates your profit. It doesn’t tell you about your cash position.
Balance sheet: While the income statement provides details about the performance of your company for a specific period, the balance sheet reflects the financial position on a certain date. It provides a “snapshot” of your assets, liabilities, and equity on the balance sheet date.
This is the balance sheet formula: Assets = Liabilities + Shareholder’s Equity.
The cash amount reflected in your balance sheet under “Assets” is the same sum that you will find at the end of your cash flow statement.
Cash flow statement: The Cash Flow statement is a crucial accounting document. It shows you the relationship between your net income and your cash balance.
Study each line item in the Cash Flow statement carefully. A scrutiny of this document will reveal why your cash balance is increasing or decreasing. The Cash Flow statement is made for a specific period. It tells you the cash balance at the beginning of the period under review and also the balance at the end. The various entries in the statement provide details for each activity which affects the cash balance of your company.
Why should you study your firm’s income statement, balance sheet, and especially its Cash Flow statement? The information that these can provide could help you in your quest to convert net income into cash.
Understanding the Cash Conversion Ratio
In addition to the three major financial statements, you must also familiarize yourself with the Cash Conversion Ratio (CCR) What is the cash flow that your company generates in comparison to its net income? Your cash conversion ratio (CCR) will tell you.
Cash conversion ratio = Cash flows % Net profits
Use the figures in your latest set of financial statements to calculate your CCR. A ratio above 1 is generally a good sign. However, if your cash conversion ratio is less than 1, it indicates that you could be facing liquidity issues.
It’s also a good idea to monitor the ratio every month or quarter. Is your CCR improving (increasing in value) or deteriorating (decreasing in value)?
Here’s how you can keep your CCR at an optimal level:
5 Ways to Convert your Profit into Cash
Take these steps to improve your cash balance:
- Manage your accounts receivable more efficiently. Does your company have a credit policy? Is it followed? Are payments tracked? It’s advisable not to extend additional credit to a customer who has delayed payments. Managing your accounts receivable well will help you improve your company’s liquidity.
- Increase your cash sales. Try and restrict credit sales. A sale that gives you immediate cash will boost your profits and your cash balance. Offer a discount if that helps. Most small businesses could raise revenues and consequently profits by laying an increased focus on marketing and by concentrating on upselling.
- Consider employing an accountant. Get professional help to manage your books. An accountant’s inputs can be invaluable in managing your company’s cash. What if you can’t afford a full-time bookkeeper or the volume of accounting work isn’t enough to keep an employee busy for the whole day? See if you can get a part-time accountant, or just use one occasionally.
- Improve your accounting knowledge. Many small business owners delegate all the work related to their finances to their accountants. This is a mistake. You must retain at least some degree of familiarity with your company’s accounts and its cash flows. This will help you to understand the financial implications of the business decisions that you take. It can also improve your profitability and cash management abilities.
- Sell unnecessary assets. Does your company own any non-productive assets? You may have bought some machinery to fulfill an order that you got years ago and know that you will never use that equipment again. Instead of letting it deteriorate, consider selling it to generate some extra cash.
The Bottom Line
Despite your best efforts to maintain an adequate cash balance, you could find yourself short of money. How will you meet your fund requirements?
Consider taking a business loan to improve your cash flow. But choose your lender wisely. High-interest rates or even taking on too much debt can put a strain on your business. Camino Financial offers a wide range of business loan options to meet your specific needs. Our loan specialists will understand your requirements and suggest an optimal solution that minimizes your borrowing costs while providing your business with the liquidity that it needs. Simply fill this online application to request a loan quote. It can be the first step to maximize the cash flow of your company and grow your business.