This is a question posed by numerous business owners during times of stress when cash is short. Often times it occurs when payroll obligations cannot be met, or a vendor or creditor is pressuring them for payment. Even more critical is when the pressure for payment comes from their lender or from State or Federal Tax Agencies!
At Tom Vignali CPA, Inc., we counsel our clients extensively on the differences between a P&L (Profit and Loss Statement) and Cash Flow Statements. We encourage our clients to maintain both forms of financial statements as each one provides individual key insights in the successful management and control of their company. Although each statement depicts and reflects specific financial activities of the business, only the cash Flow Statement reflects current and projected available cash. It is entirely possible that a company can be profitable but have inadequate available cash to meet their current needs.
Here are some key points to consider if a company is using the accrual method for their accounting:
What P&Ls Tell You – And What They Don’t
The P&L does not reflect cash balances, only the Cash Flow Statement and Balance Sheet will do that!
Income is reported at time of invoicing, but it does not reflect whether or not the invoice has been paid. What has not been paid (cash collections) is reported as an outstanding A/R (Accounts Receivable), or monies due. So, if you sell $10,000 worth of goods that have a cost of $5,000 and you are paid $5,000 at time of sale:
The P&L will reflect revenue of: $10,000
The A/R Report will reflect a balance due of: $5,000
The A/P Report will reflect a balance due of: $5,000
The Cash Flow Statement will reflect cash receipts of: $5,000
The P&L will also reflect the COG (Cost of Goods) for the products sold for $10,000. And, it will reflect the GPM (Gross Profit Margin).
Revenue $10,000
COG – 5,000
GPM 5,000
The P&L will not reflect how much cash you have. The GPM amount reflects the funds available to pay for G&A (General & Administrative Expenses), ie: rent, payroll, loans and other expenses related to the cost of doing business. So, in this simplistic example you have a GPM of $5,000 on the transaction. After you pay for G&A expenses and other expenses, what is left over is your Net Income. This figure will indicate your profitability. If you use all of the initial payment of $5,000 to pay for G&A expenses, you will have no cash available to pay the vendor the $5,000 for COG. If you pay the vendor the $5,000 for COG from the funds available from the initial payment, you will have no cash available to pay for current G&A expenses. It’s all a matter of timing, and this is why Cash Flow Statements are so important in calculating the cash needs of your business. If you have to pay the vendor before the customer makes the final payment, you will need cash from another source to cover current G&A expenses.
So, calculating payment terms from customers and to vendors is a critical factor in calculating how much cash you will have available to pay your vendors and paying for G&A expenses. The P&L will never tell you how much cash you have and when. So, it is possible for your company to look profitable on the P&L Statement, but you might not have enough cash to meet current financial obligations.
Now, the above example is overly simplistic just to illustrate some basic concepts regarding cash flow. Things get much more complex as more customers and vendors and variable expenses get inserted into the equation.
Let’s just be clear:
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- P&L’s identify Revenues and Expenses.
- Cash Flows identify “cash in” and “cash out”.
On an accrual basis:
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- Revenues do not reflect “cash in”.
- Expenses do not reflect “cash out”.
So, you can be “profitable” and “cash broke”!!!!
Let’s look at some specific differences:
A P&L will list depreciation as an expense, but a Cash Flow will not.
A P&L will list the interest on a loan as an expense, but not the principal. A Cash Flow will list the entire loan payment as an expense.
A P&L will list all revenues as revenues, a Cash Flow will only list the cash collected.
A P&L will list all expenses as expenses, a Cash Flow will only list the expenses that have been paid for.
Let’s look at some other timing issues:
Lets assume that your revenues are static throughout the year and your expenses are fixed and static as well. How could you be profitable, but find yourself with some months that you didn’t have enough cash to pay your bills?
Insurance Policies which might require an up-front deposit of 30% with the balance due payable over the balance of the year. The month that the deposit is due would require significantly more cash than other months.
If your payroll is paid weekly, one might assume that every month’s payroll would be the same amount. But since there are 4 5-week months, during those 4 months your cash outlay for payroll would be much greater than during the other 8 months.
Lines of Credit which might need to be paid down on an annual basis as well as certain annual tax payments might also have an impact on cash flow.
There are a variety of other one-time annual payments or renewals that might reduce your available cash from one month to another.
Let’s look at a classic mistake:
A vendor offers you a fantastic deal on a product(s) which allows you to make a purchase at a 15% discount. You assume that this discount will increase your bottom line if you purchase the product(s) at the discount but don’t respectively reduce your sales price. Unfortunately, if the minimum amount you need to purchase in order to obtain the discount is a 3 month supply, but the payment terms remain the same,….where will the cash come from to pay the vendor while 2 months supply remains in your warehouse unsold? The deal might have a great GPM, but if it doesn’t generate enough cash to support the purchase, or, if you don’t have enough cash available from other transactions, then all you’ve done is deplete available cash and increase your inventory.
Cash Flow Statements also provide insights into:
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- Changes in available cash
- Changes in Inventory
- Changes in A/R
- Changes in A/P
- Sources of cash: Operations, Financing, Investments
Many times a commercial lender will require a business loan applicant to provide them with a monthly pro forma P&L and a monthly pro forma cash flow statement for the first year, with year 2 and year 3 on a quarterly basis. The P&L will identify profitability month to month, and the cash flow statement will identify the ability to meet cash demands on a month to month basis. Despite profitability, this process might identify a month(s) when there is inadequate cash available to meet cash demands, like the loan payment!
There are numerous other issues which we did not discuss here, they will be outlined in a future blog on Cash Flow Management.
Hopefully, we have identified the importance of Cash Flow Statements in the effective financial management of your company.
Contact Us:
Thomas W. Vignali CPA Inc.
118 Point Judith Road
Narragansett, RI 02882
T: (401) 415-0798
tom@tomvignalicpa.com
www.tomvignalicpa.com
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