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Monday, March 06, 2017
Is Your Profit Real?
You’ve just invoiced your clients for the work you did over February. It was a good month – you’ve never been so profitable!
For a long time, you’ve sworn that when you have enough cash, you’ll invest in a new piece of equipment that will push your business ahead.
Should you go ahead and buy it?
Now, obviously there are many variables here so this is a bit of an impossible question.
But I’ll give you my two cents (or rather, two pence) anyway.
Until you see that cash in the bank, you can’t count on it ever materialising.
It may look like you’re in profit, but that’s just theoretical until your clients actually pay up, and your money is safely in your account.
If that didn’t occur to you, you’re not alone.
Many business owners find it hard to internalise the difference between profit – and cash. It’s one of the main reasons companies go out of business.
Here’s how I think of it.
Profit is a number your accountants create to show how much money your business is making. It is both theoretical and subjective. People can have different opinions about just how profitable their company actually is, and there are different ways of measuring it, too.
Cash, on the other hand, is real and objective. It’s the money you have in your account at any one time…. You can always put a figure on it.
The problems start when you confuse the two.
As a business owner, you might see lots of money in your account and think it’s all there to spend.
But whoah! Hold on a second. Lots of cash doesn’t mean you have any profit.
Later in the month, you might have a lot of obligations coming down the line: Tax, wages, rent and so on. If you’ve already spent that money you won’t be able to meet those liabilities, and the very viability of your business will be threatened. Your “cash” doesn’t become “profit” until you’ve covered all your overheads.
The example I started this email off with is the polar opposite. Business is going well, you look profitable on paper. But that doesn’t mean you actually have any cash.
Ask all the businesses I’ve come across who have had to sue to get money owed to them.
And by the way, that’s a good example of a case where profit is subjective.
What if you think that the money will be easily recoverable, while your business partner has written it off as uncollectable? You might think that despite the delays in collecting your cash, you are still quite profitable. Your business partner, on the other hand, thinks your profit has disappeared.
For a long while, it really might not be clear how profitable you are, if at all.
And that really is the key. To understand how much money you’re really making, you need to take the long view.
You need to understand not just what’s in your account and on your balance sheet today, but what’s going to happen tomorrow as well: Which bills are coming in, which payments are going to materialise…. How much money you’re really going to be left with a few months down the line.
For that, you need excellent accounts, which look forward as well as back.
Over my next few blogs I’m going to show you other common accounting mistakes that business owners either make themselves, or overlook when their bookkeepers make. These can be ruinous, because they give you a skewed view of what’s really going on with your finances, and lead to bad decisions.