For too long, cash flow forecasting hasn’t been the bride, it’s not even been a bridesmaid, instead, it is regarded as a dull “necessary” task…like the infamous seating plan. So, in our mission to change your perspective about the joy of forecasting and demonstrate why your business plan and cash flow should live happily ever after, we look behind the lens to explain why profit is vanity and cashflow is sanity.
Let’s use an example to really bring this to life…
Sarah took over her father’s well-established wedding photography business which has seven staff and averages 20 weddings a month at $2,000 per event.
20 * 2,000 = $40,000 revenue, per month
Her total costs are roughly 50% of her total income, so the business has a nice monthly profit of approximately $20,000. At the beginning of the year, Sarah, as usual, prepared her budget. This included loan repayments for new (expensive) equipment as she and the team all needed upgraded hardware. 7 new camera bodies ($2,500 each) and a series of 20 new lenses ($500 – $2,000 each) meant that Sarah was investing approximately $37,500 into the business. However, she was anticipating $20,000 being deposited into her account every month from the business profits, which in theory was more than enough to cover her outgoings, so it seemed that it wouldn’t just be the bride smiling, right?
Wrong. The problem is profitability just isn’t the same as positive cash flow. Sarah managed to maintain her objective of averaging 20 weddings per month but didn’t account for the timing of her cash inflows. Several months later, she quickly found that she’d maxed out her overdraft and was scrambling to get a small business loan to stop herself going out of business. So how did it go so wrong?
Well, Sarah’s decision to take out credit to pay for an upgrade to the companies photography equipment was based on the premise that she would receive a steady flow of income from each event to match the business’ outgoings. She allowed 30 days for invoice payments, however, she didn’t anticipate the extent to which people would run late with their payments, and that she would be chasing for sometimes double that length of time.
So whilst the business continued to be profitable, there just wasn’t enough cash flowing into the bank account to meet all her outgoings.
The lesson here is that profitability does not equal cash. Don’t focus only on your income statement and instead draw insights from your cash flow statement so that you make more realistic and better business decisions.
This is such an important concept and it is one we’ve been surprised to learn is not common knowledge. Business owners…and some accountants…have struggled to explain, clearly, what this is and why it is important, in layman’s terms that any business owner can understand.
FUTRLI’s Co-Founder, Hannah McIntyre, to shares her thoughts on the confusion…
“Just like Sarah in this example, too many business owners will look at their profit & loss and think they are ticking along nicely until they have a GST bill to pay and can’t understand why there isn’t enough cash in the bank, hence the old adage, “Profit is vanity and cashflow is sanity”. It’s sometimes a cruel lesson and the reason that most SMEs fail: Cash flow HAS to be your number one priority and cash flow breakeven is the holy grail. If your clients aren’t getting it, use this simple example to help them understand”
Even Kayne West has felt the strain of cashflow issues and his lavish wedding to Kim Kardashian probably didn’t help. If you want to find out if your business is going to run out of cash, read the 6 simple steps on the Futrli blog.
Three key takeaways
The happy couple – Positive cash flow
With this, like the happy couple, your business can live happily ever after.
It shows that the business’ liquid assets (assets that can be converted into cash quickly) are increasing and it’s a good sign that your business is healthy. A positive cash flow allows your company to reinvest and most importantly future-proof you against any unforeseen financial pitfalls. In the case of our wedding photography business, they should’ve waited to invest in their expensive cameras and lighting equipment, or at least staggered the payments, until their cash flow was looking more positive.
The drunk uncle – Negative cash flow
You don’t want your business to be the drunk uncle at the wedding, stumbling about and being avoided by the guests at the party.
Negative cash flow suggests a business’ liquid assets are decreasing, and this is when alarm bells should start ringing and you should look at ways to reduce costs to stay afloat. This was the reality of the situation for our photography business and the root of their problems. Despite sending out lots of invoices for all the work they’d done, they were struggling to get that money into their bank account in a timely fashion. They could automate this process or they could look at a payment plan to make sure 80% of the wedding is paid for before the big day. Additionally, if Sarah shared the photos once the final amount was cleared in the bank, she wouldn’t have run into these issues.
The best man – Profit
Any groom will tell you that the best man’s speech is an over exaggeration of the truth!
Otherwise known as Net Income, this is what’s left over from revenue after all the business expenses are subtracted. It’s important to understand that this includes items for which payment has not yet been received. These can appear on your balance sheet, but they are incomplete transactions and they don’t count as cash. This is what confused our wedding photography business. They were anticipating all the revenue for the weddings they were doing, before having actually received the money from the invoices they’d sent out. This made it seem like they had more available cash than they actually had and encouraged the owner to make poor business decisions.