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How to turn profit into cash
February 11, 2013 | By Neil Ducoff | 3 Comments
One of the great mysteries in business is why profit isn’t cash. Well, it’s not really a mystery – profit is more like an abstraction that requires further interpretation to fully understand its meaning. We can all agree that creating profit is a good thing and that negative profit (loss) is a bad thing. However, the mind games begin when there is profit but no money in the checking account. And why don’t you go out of business when your profit and loss statements keep showing negative profit? The answer is simple: profit isn’t cash. Hmmm … perhaps it is a mystery after all.
The most important fact to remember about profit is that it has no connection to how much cash is in the bank. For example, you ring up a sale that’s paid for with a gift card. Your Profit & Loss Statement shows the sale, but the cash from the gift card purchase may be long gone. If you enter an invoice for $5,000, your Profit & Loss Statement shows the sale and resulting net profit, but there isn’t any cash until the invoice is paid. When you make a loan payment, only the interest portion of the payment appears on your Profit & Loss Statement while the principle portion of the transaction occurs on the Balance Sheet. In this case, a portion of profit was used to pay principle.
It’s not smoke and mirrors – it’s just having a basic understanding of how transactions occur on your Profit & Loss Statement and your Balance Sheet. The goal is to make better financial decisions.
Here are some no-compromise strategies to turn profit into cash:
- Plug the cash leaks: Waste, inefficiency, and unchecked spending siphon off precious cash right under your nose. As a leader, you may even be the biggest offender. Paying overtime because of poor scheduling practices or slow work performance saps cash. Poor inventory control and purchasing too many “wanna have’s” before your “gotta have’s” saps cash. Take a forensic trip down your Profit & Loss Statement and justify every expense line item. I bet there is 5% more profit just waiting to find its way to your bottom line – and with profit comes cash.
- Debt sucks: Too much debt sucks the financial life out a company. Remember, principle payments occur on the Balance Sheet and are funded by profit. If you’re profitable and overburdened with debt, chances are your company is cash starved. If you’re not profitable AND burdened with debt … well, you’re in big trouble. The only way to begin eliminating debt is to put yourself and your company on a strict debt reduction diet. Step one is to STOP adding debt. If you don’t have the cash – don’t buy it. Step two is to build a budget that should include extra effort to pay down principle, and then stay faithful to it. Be prepared and disciplined for the long haul – it’s going to take time.
- “Sleep good at night” money: Building and protecting your company’s cash reserve is simply responsible leadership. Without cash reserves, a company is forced to live out of its checkbook and add debt through financing or on credit cards when cash is short. It’s an ugly and dangerous cycle to get into that typically sees the debt mountain grow rather than shrink. Building a cash reserve is a discipline that requires moving cash from the checking account into a savings or money market account. Once there, that cash must be protected and only used when absolutely necessary. How much should be in your reserve account? Three to four months operating expense is a realistic target. Seriously. No compromise.
- Staying healthy: Too many leaders focus on the Profit & Loss Statement. That’s fine, but it only tells how your company is performing with respect to driving revenue and managing expenses. It doesn’t tell you how healthy your company is. That’s the job of the Balance Sheet. It tells you what you own (Assets), what you owe (Liabilities), and what you’re worth (Equity). Assets always equals liabilities plus equity. If your liabilities exceed your assets, your equity is negative. That’s bad. It’s like owing more on your home than it’s worth. Make financial decisions based off of your Balance Sheet. That means deciding if you want to add debt to buy something, or pay cash. If you don’t have the cash – don’t buy it. No compromise.
- It’s not personal: Keep your personal expenses out of the company. Once you mingle your personal expenses in with your company, your financial reports are contaminated and pretty worthless when it comes to decision making. Besides, the proper term for this practice is “tax evasion.” If you run a clean company, grow profit, and manage cash, you can pay yourself better. That’s your reward for being a savvy businessperson.
Turning profit into cash is a planned occurrence. It means living your Cash-Flow Plan every day. It means making financial decisions knowing the potential positive or negative impact it will have on your Balance Sheet. As the leader of your company, it’s your responsibility to keep its Balance Sheet healthy. No compromise.
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