Have you ever had your best month in sales and profit, only to see your bank account decrease? Or wondered why your accountant says you made more money than you actually have on hand? This discrepancy lies between profit and the elusive cash flow. This blog is derived from Episode 125 of Business by the Numbers, go here to listen!
Why Understanding Cash Flow is Crucial
I often joke that whenever I tell a client they’ve made a significant profit, their immediate response is, “There’s no way I made that much money.” They’re certain because they don’t see that money in their bank accounts. This used to puzzle me until I realized the real issue: many people confuse profit with cash.
The Basics: Profit vs. Cash
Let’s start by understanding the difference. Profit is what you make after all expenses are deducted from your revenue. Cash flow, however, is the actual money flowing in and out of your business. While profit is a crucial indicator of your business’s success, it doesn’t pay the bills—cash does.
To illustrate, consider a simple business model like a lemonade stand. The owner sells lemonade, gets cash immediately, and uses that cash to buy more lemons. The profit they make is immediately visible in their cash on hand.
However, auto repair shops are more complex. When you started, you probably operated on a cash basis. Customers paid you directly, and you paid for parts with cash. There were no accounts receivable, inventory, or payables. Whatever you made was what you had in the bank.
As your business grows, it becomes more complicated. You start dealing with accounts receivable, inventory, and other assets that can create a significant lag between when you record a profit and when you actually see the cash.
Major Drivers of Cash Flow
Let’s discuss the three major categories that affect your cash flow:
- Accounts Receivable (AR): This is money owed to you by customers. Even if you don’t offer credit, you likely have AR due to the timing of transactions. For instance, you close a job at the end of the month, but the customer pays a few days later. During this period, you have recorded a profit, but you haven’t received the cash yet.
- Inventory: Buying inventory reduces cash but doesn’t immediately impact profit. When you sell the inventory, your profit increases, and ideally, your cash should as well. However, large inventory purchases can create significant cash flow swings.
- Fixed Assets: Major purchases like equipment are recorded as assets, not expenses. If you buy equipment with cash, your bank balance decreases, but your profit remains unaffected. On the other hand, financing these purchases through loans can keep your cash stable initially but will affect your cash flow over time as you repay the loan.
Managing Liabilities and Equity
Liabilities like loans and accounts payable have a direct relationship with cash flow. Increasing liabilities, like taking out a loan, boosts your cash. Conversely, paying down liabilities reduces your cash. Similarly, equity transactions, such as owner draws, directly impact your cash flow.
For example, if you made $100,000 in profit but took a $100,000 draw to pay estimated taxes, your bank balance wouldn’t change. This is a common situation where owners wonder where their money went, not realizing it went towards taxes or personal expenses.
Practical Tips for Managing Cash Flow
- Monitor AR and Inventory: Keep a close eye on accounts receivable and inventory levels. Ensure timely collections and manage inventory efficiently to avoid tying up too much cash.
- Plan for Major Purchases: Before making significant asset purchases, consider the impact on your cash flow. If possible, finance these purchases to spread out the cash impact.
- Manage Personal Draws: Be mindful of the amount of money you withdraw from the business. Excessive draws can drain your business’s cash reserves, even if you’re profitable on paper.
- Understand Your Financial Statements: Regularly review your profit and loss statements, balance sheets, and cash flow statements. Understanding these documents helps you see the complete financial picture of your business.
- Seek Professional Advice: If you’re unsure about managing your cash flow, consult with a CPA or financial advisor. They can provide insights and strategies tailored to your specific situation.
Conclusion
Understanding the difference between profit and cash flow is crucial for the financial health of your auto repair shop. While profit is essential, cash flow is what keeps your business running day-to-day. By monitoring key drivers and managing liabilities and equity effectively, you can ensure your business remains financially stable and successful.