In last week’s article, I ran through an example of where the cash goes in a business and why there is often the question at the end of the year “How is it that I have a profit but no cash”?
As the graphic at the top of the article illustrates,
- Cash is generated from business activity
- Assets are used to generate income
- Profit is the return generated on these assets
- Owners is the investment held in the business
So what does this all mean?
When looking at cash, there are activities that we can categorise as “cash gains” and others as “cash drains”. Things that contribute to cash gains include faster collection of accounts, decreases in stock/work in progress and slower payment of suppliers. Conversely, cash drains are the opposite; slow collection of debtors, increase in stock/work in progress, loan/tax payments and faster supplier payments.
When looking at profit, gains arise from things such as sales growth and margin growth whereas drains arise from unchecked overhead expenses.
Assets are integral in the generation of profit and they need periodic replacement. This is often done via loan financing which in turn requires cash flow to service repayments. Infrequent maintenance of assets could result in more regular replacement and therefore present a potential cash flow drain.
Owners need to be remunerated so there are drawings/wage payments that need to be made. Left unchecked, these could be a significant drain on the business.
When we prepare Cashflow Forecasts for our clients, we focus on this cycle as it ensures you’re going to increase your cash as much as possible. Ultimately, we want the gains to be higher than the drains, so focus on reducing the drains and increasing the gains.
