Friday, December 14, 2007

But I Have More Money in the Bank Than Ever!

So often, small business owners get fooled into following their bank balance. They think, "Well, I know at the end of last month I had less than I do right now, so of course I'm making money."

Cash is not a measure of profitability. I know accounting to most people is Greek for math voodoo, but without understanding some basic principles of how to account for transactions, many a business owner is lost in the sea of numbers. The fact is, cash rarely has any correlation to profit. For instance, what happens when a company dramatically increases sales suddenly? They're hoepfully increasing their profit at the same time. But what about cash? If they sell on credit, then their cash may actually decrease. They may have to purchase more inventory, pay salespeople their commission, or otherwise use cash while they wait to get paid. In my business, I pay a driver the day he gives me his paperwork for a load, but I wait thirty days (in most cases) to get paid. During our heaviest billing periods, we have to borrow on a line of credit to keep up with our volume of sales. If we only watched our bank balance, we might do something silly like reduce sales to avoid losing money. The other danger of not understanding this inverse relationship that some companies face is selling themselves out of business. One competitor of ours hired someone they knew would bring in a lot of new freight, hoping his increase in sales would save them since they were running out of cash. Instead, his increase in sales destroyed their business as they were forced to change payment policies and drivers lost all trust in them. Not long after, they closed their doors.

Cash is definitely important to monitor. Cash is definitely nice to have, too. Understanding how little it has to do with profit, though, is paramount to grasping what a business really does day to day, and whether that business is profitable or not.

-- Robert

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