Quiz yourself: Can you explain the difference between profits and cash flow? And why should you care?
The answer to that question requires a basic financial understanding that will allow you to run your business more effectively. Note that I am not talking about a commanding “CFO level” knowledge that would allow you to run Monte Carlo simulations (risk sensitivity analysis scenarios) or to be an accountant or a financial analyst. If you don’t have it now, don’t feel bad, you are not alone. There are huge numbers of successful business owners who tell me their eyes “glaze over” whenever anyone tries to talk to them about finance. Isn’t that a shame, when finance can be so much fun?
Finance wasn’t fun for me either until I had great teachers (both in school and in business) who “showed me the way”. And although I am interested in some of the concepts my sister (the CFA) has shared with me about how portfolio analysis is performed, I will tell you I am not interested in solving simultaneous equations. I will say, though, that a basic knowledge of your financial statements and how to analyze them can help you run your business more profitably. The financial statements are a window into the company’s operations.
So for today, a brief answer to our question. A smart owner will watch both earnings and cash flow:
- Earnings –measure how revenues generated during the accounting period exceeded the related expenses incurred in generating those revenues. Earnings (aka profits or income or net income) are based on promises, not money coming in.
- Cash flow –the conversion of cash into work and then back to the company via accounts receivable is the lifeblood of the company.
There is a simple answer for why earnings are not equal to cash. Cash is the money you have in the bank plus anything else that can be converted to cash quickly. Earnings (or income or the other names for it) is the excess of revenues over all related expenses for the given time frame. This is called accrual accounting. There can be a serious lag between revenue being generated and cash being collected. Other “non-cash” items will also affect earnings. These would include depreciation and taxes. Depreciation is a really fun topic (not really) but there are a few basics we can cover in the future. I apologize if this seems very basic, but I do think it can be a helpful refresher at a minimum!
In the meantime, if you have any questions or comments about this topic, or if you’d like me to address something in particular in a future blog, please email me at [email protected] or call me at 224-688-8838. We’re here to help you harvest your potential!