Why don’t I have any money?

Dun & Bradstreet's National Business Expectations Survey looking at Australian businesses released early this year reported that more than 68 per cent of executives indicated that cash flow will be an issue for their business's operations for the June 2013 quarter, while more than 28 per cent rated outstanding accounts receivables as their biggest barrier to growth.

A plaintive cry from small business owners I've heard so often ove the years is “The accountant says we are profitable.  So why don’t I have any money?”

In fact I think we all puzzle over this at times.  So let’s start with the whole concept of profit, how it is measured and the link between cash flow and profitability.

The Concept of Profit

Profit is the difference between the sales price and the component costs of delivered goods and/or services plus any operating or other expenses.  

The first bit is clear – “component costs of what you deliver”.  Those component costs could be goods you buy for resale, or you use parts and materials that to make, repair or service something.  It also includes the cost of labour that go into the latter.

Economists call this a “variable cost”.  The more you sell, the more components you need.  If you are not selling as much, you don’t stock as much.

The second bit is also reasonably clear – “any operating or other expenses”.  These are your overheads; the costs of being in business.  They cover things like rent, advertising, electricity, accountant & legal cost and so on.

In the short term at least they won’t change much, so they are also known as “fixed costs”.

Here’s the thing and it sounds kind of funny.  

  • “Variable Costs” per unit are fixed.  Whether you sell 10 or 100 units each will still have the same amount of hours, materials and parts in it.  (I’ll ignore economies of scale for the moment.)
  • “Fixed Costs” per unit will vary depending on the amount you sell.  If your Overheads are $10,000 for the year and you sell 1,000 units you will need to recover $10 per unit as well as the Variable Costs going into each unit.  If you sell 2,000 units you only need to recover $5 per unit.

That is why budgets are important.  You need to have a best estimate on how you need to sell to recover all your costs for the year.

How do you Measure Profit?

When you started your business it would be a fair guess you used what is known as ‘cash accounting to record what was happening in your business’; in other words you recorded your sales when you actually received the money and your expenses when you paid your bills.  

Profit is what is left over.  It is only measured after you have received payment and paid; very much a lag indicator.

The weakness with this approach is that you may have cash due to you from sales made but not yet fully paid for; i.e. debtors, or you owe money on purchases that you have similarly not paid for, i.e. creditors.  But if you don’t know how much is in each you can lose control of your business, and losing control can cost you your business.

Read this real-life case study to see just what the impact can be.

It is better to use what is known as “Accrual Accounting”.  

‘Accrual accounting’ records the transaction when it occurs and then monitors the accounts so you have control.  

And this is where that anguished question comes from.  Accrual accounting shows you’ve made a sale, recorded your costs and hopefully shows that you have made a profit.  But until those pesky debtors pay up you are profitable from an accounting sense but have no money.

That is just what happened in the Case Study.  In fact the Creditors ended up funding the business.  Believe you me; you don’t want that to happen.

Understanding just what is happening in your business is just so important.  Of course there may be more to the problem than just how your figures are recorded and reported.

Often the only KPI many small businesses have is their bank balance.  The problem with this is that the bank balance is a reflection of decisions made some time in the past.  It doesn't tell them where the problem may lie.

You may need to throw some light on the dark recesses of small businesses where the profit leaking demons lurk.  The problem for many small businesses have is that they just don't know.  All they know is that they don't have enough money and they are struggling.

Next posting I’ll look at some specific steps you can take to improve the situation.

© Copyright 2013 Adam Gordon, The Profits Leak Detective

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