Why Cash is King… not profits
Believe it or not, even the most profitable companies can fail — and when they do, they’re always caught by surprise. One month, they’re saying, “Profits are up! The numbers have never been better!” but the next month, they’re announcing that they’re closing their doors.
How can a profitable company fail? Their undoing happens at the hands of three words you never want to say about your business: short on cash.
You’ve heard the expression, “Cash is king.”
Here’s why it wears the crown.
Confusing “profitability” with “cash flow” puts your startup at risk.
Financial jargon is called jargon for a reason — it’s not only confusing, but many of the words are used casually as if everyone understands them. In our everyday lives, it’s usually not a big deal since our ordinary conversations typically don’t need that level of precision. But in business, these words matter.
This is especially true with words like “profit,” “cash flow” and “working capital.” If you don’t understand the differences, you’re putting your startup’s financial health at risk.
So let’s look at the definitions of each of these terms (and if you’d like a more extensive primer on financial vocabulary in general — explained in plain English — read this next).
Financial terms to know.
Profit is the money your business makes after all costs and expenses are paid, and is calculated in your financial projections on your profit and loss (or P&L) spreadsheet. This money can be reinvested in the business (to help it grow), or paid out to founders, investors, etc.
Cash flow refers to the money flowing into and out of your startup’s bank account, which affects the amount of money your company has on hand and is calculated on your cash flow projections spreadsheet. (You can learn about all five basic spreadsheets here.)
Working capital is the cash your company has access to right now to pay its bills when they’re due (like rent, payroll, this week’s office supply run, etc.).
And there’s one more term — liquidity — which refers to how quickly you can get your hands on cash if you need it in a hurry. So if you have assets that can easily be converted into cash (without affecting its market price), they’re the next best thing to having actual cash in your company’s bank account.
Profits don’t pay the bills — cash does.
You can have all the profits in the world, but if you don’t have enough money in the bank — working capital — you can’t pay your bills.
And if you can’t pay your bills, you can’t keep your doors open and the game is over.
This is why cash flow is so important. Cash on hand is what’s going to make or break your ability to cover your expenses in real time. You can’t just depend on what your P&L says — if money needs to flow out this week, you have to be able to get your hands on it now.
People can get tripped up on this while looking at financial projections.
Timing is everything.
As consumers, we all know that not all sales are cash sales. Most of us, and businesses even more so, rely on credit, whether we’re talking about credit cards or waiting for an invoice to arrive before paying a bill.
Credit slows down the timing of when cash flows into and out of your bank account.
Cash in. Let’s say one of your customers purchases a $10,000 batch of widgets this week… but they won’t be paying their invoice until next month. That means you won’t have that ten grand now when you need it to pay your rent, for example. On paper, you’re beautifully profitable. But until that money is in your bank account, it doesn’t matter.
Cash out. On the other hand, let’s say that one of your suppliers has offered you payment terms of net 60 (which means you have 60 days to pay the invoice) for the $5,000 of supplies you purchased two weeks ago. You still have that money in your bank account today because you’re planning to play that invoice in a few weeks.
These two examples show you why you need to pay extra attention not only to how much money you have in the bank right now, but also to the timing of how money will move into and out of your account.
If it takes too long for customers to pay you, you could end up in a cash crunch. (And if you’re relying on extended payment terms to pay your own bills, you’re playing a dangerous game.)
At the end of the day, cash is what pays the bills, and that’s why cash flow projections are so crucial for your startup. They’re the key to avoiding a cash crunch that could cripple or kill your business.
Cash on hand gives your business 3 strategic advantages.
Having enough working capital gives your startup superpowers that the cash-poor startup lacks. You’re already familiar with these superpowers in your day-to-day personal finance, but the stakes are higher with your business, so cash has an even greater importance.
1. Cash helps you survive unexpected setbacks.
Murphy’s law is alive and well, and in business (as in life), a surprising number of things don’t go as planned.
Customers and clients pay late (or dare I say, never). Supplies end up being more expensive than what you originally planned. Equipment breaks at the worst possible time, and you have to shell out a substantial amount of money just to keep your business moving.
When you have even liquidity you can absorb all of these unhappy scenarios with ease, if not pleasure. It makes setbacks feel like an inconvenience, rather than a crisis.
2. Cash gives you the freedom to seize opportunities.
The flip side of Murphy’s Law are those moments when opportunities knock. Cash on hand gives you the flexibility to seize unexpected opportunities that are advantageous for your business.
Maybe a favorite supplier declares bankruptcy and marks down their inventory by 50% — and you can stock up and save a fortune. Or QVC calls with an opportunity to be on their show — but you have to fly out your team on Monday and get ready to produce more inventory.
As the old saying goes, “Luck is where preparation meets opportunity” — and for your business, access to cash is the ultimate in preparation.
3. Cash gives you the ability to retain your focus.
Again, this is just as true with your personal finances as it is with your business. When you’re too tight on cash, it’s distracting. It preoccupies you, on some level, during all of your waking hours and it makes you more fearful and conservative.
This isn’t good for you, and it’s not good for your business, either. You need to retain your ability to think strategicallyand do what’s best for your startup, without having nagging money worries throwing you off your game.
Plus, you free up that part of your brain that would be thinking, “What am I going to do if I can’t make payroll next month?” It can think better thoughts, like, “How can I make my customers more likely to buy from me?”
You don’t need a war chest, but you should have a cushion.
Running short on cash can kill even the most profitable of businesses — so don’t let your P&L (or today’s profitability) cloud your vision. There’s no substitute for easy-to-lay-your-hands-on money in the bank.
Perhaps you’re fortunate enough right now to have a cash cushion that gives your startup those game-changing superpowers. If so, that’s great. But if you don’t, then please prioritize making a plan to start building up that cushion moving forward. You don’t need the riches of Midas here, but you do need something.
And if you need any help getting your cash flow projections or other financial projections wrangled into shape, there’s a lot I can help you with on that front. Take a look at my startup advisory services here.
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