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Cash Flow Management: the Difference between Profit and Cash

Managing cash flow in a small business is crucial to its success. Cash flow management includes techniques for collecting cash, budgeting to plan for cash needs, utilizing outside sources such as banks or investors to supplement cash needs, and even legally minimizing business tax liabilities. Techniques for dealing with these functions can range from the simple to the complex, depending on the nature of the business. 

However, one of the most basic ideas is to understand the difference between profit and cash flow.

Cash-based Business

A business that sells its goods or services for cash will not have to deal with this issue. Profits are generated when a sale is made and, therefore, are the same as the cash coming in. Examples might be a retail store, restaurant, or service business such as a plumber or accountant. This is known as the cash basis of accounting. 

Most small businesses operate this way and the accounting process and management of cash flow is fairly straightforward. The business owner simply needs to make sure that sales are enough to cover the expenses of running the business and the personal cash needs of the owner(s).

Businesses That Give Their Customers Time to Pay

Some businesses will sell their goods and services but allow their customers to pay them later. In this situation, the customer is given a bill, invoice or statement that will specify how long they have to pay. Repayment terms vary considerably but, in general, thirty days is normal. 

Examples might be an auto parts store that sets up an account for an auto repair shop that makes many purchases over a period of time, or a manufacturer who buys parts or materials from a supplier. This is known as the accrual basis of accounting.  Many larger companies operate this way, although size is not always the determining factor. This involves more complex accounting methods because now, according to accounting and tax rules, there is a difference between profit and cash flow. Just looking at the bank balance is not enough.

Keep in mind that some businesses will combine both types of methods which can add to the complexity.

Cash Basis Versus Accrual Basis

Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Code (IRC) allow for both types of accounting methods. GAAP is concerned with accounting that provides users of a company’s financial information such as investors and banks (external users) and company management (internal users) with a level of standardization in using the information. 

The IRC is concerned solely with raising tax revenue but allows for methods that allow all taxpayers to legally minimize their taxes. GAAP is fairly rigid but, surprisingly, the IRC allows for some interpretation.

Accrual basis accounting is the norm from a GAAP standpoint unless your business is truly a cash-based business. However, the IRC allows both methods and the business taxpayer can pick the treatment that legally minimizes their tax liability. As a result, one may find many businesses that use accrual accounting for their financial affairs but convert the books to cash accounting for tax purposes.

Profit Versus Cash

Under the accrual basis of accounting, there is a difference between profit and cash. This is not the case in the cash basis of accounting. We will focus on the accrual basis.

Under the accrual method, income is recognized when it is earned (not received) and expense is recognized when incurred (not paid). This leads to the concept of receivables and payables.  

In the cash basis of accounting income is recognized when received and expenses are recognized when paid. There are no receivable and payables, just an increase or decrease in the bank account. Profit and cash flow are the same.

When receivables and payables are involved, cash flow issues can become acute if not managed timely and properly. If a business allows customers to take longer to pay than the invoice states, the gap between profit and cash flow widens. If allowed to go too far, the business may not have enough cash to meet its requirements even though it looks profitable. 

On the other hand, if a business pays its bills quicker than their suppliers allow them, they are letting cash go out of the business when it might be used for other needs. Again, the gap between profit and cash flow widens.

Using Aging Reports to Help Manage Cash Flow

As mentioned before, there are several ways to manage cash flow. Focusing on receivables and payables, the use of aging reports can be very helpful.

An accounts receivable aging report is simply a list of customers who owe your business money, how much they owe and how long they have waited to pay. The more time a customer is given to pay from the time an invoice was issued reduces cash flow to the business. Keeping in mind that several invoices issued over different time frames to the same customer may be outstanding, it becomes important to follow up with them if they start to get too far behind.

There are many collection techniques that can be used to do this, but the point is to know how much they owe you and how far you have let them go in comparison to the terms you have extended to them. The longer they are given to pay may also ultimately result in a bad debt, which can be written off, but which also adversely affects cash flow.

An accounts payable aging report is a list of vendors to whom you owe money and how much time they are allowing for payment. The goal here is the opposite of that with receivables. The longer the time period, the better the cash flow. 

However, waiting too long to pay may result in collection efforts against your business and the withdrawal of credit from suppliers who provide crucial goods or services.

Discounts

When receivables and payables are involved, the concept of discounts received and taken can also affect cash flow. Simply put a discount is offered to promote early payment. This affects the cash flow of both the vendor and the customer. The vendor will offer a discount, such as a 1% discount on the total invoice if the customer will pay within a certain time frame (i.e. 10 days instead of the full payment terms). This will speed up cash flow and decrease the gap between it and profit. 

A customer, likewise, can reduce the amount of cash flowing out of the business by promptly taking all discounts offered by their vendors. Knowing the relationship between profit and cash flow can help business owners determine the benefit of taking or offering these discounts.

Cash Flow Management Conclusion

Cash flow management in a business is crucial and involves numerous techniques. Understanding the relationship between profit and cash flow, particularly in a business that uses the accrual basis of accounting, is one of the more straightforward methods of managing this process.

Many larger companies may employ a Controller and/or a Credit Manager to handle these matters. However, many firms cannot afford to hire a full-time employee for those duties. A small business financial advisor, such as a Certified Public Accountant (CPA), can help those business owners ensure that this information is being recorded, put into an appropriate report format and how that information can be used to manage cash flow issues. 
Get a free consultation with our CPA firm.

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Do I Need a Business Plan?

If you own a small business or are thinking about starting one, the question of business planning usually comes up. Yet, most small businesses rarely have a written business plan in place at any time during their existence. There are several reasons for this:

  • Business plans are intimidating.  There are a too many books on the subject, most with long, detailed processes on how to do it, and, if followed, most result in a plan that is a book in itself.
  • The owner of the business doesn’t have the time to do it because they are too busy running their business.
  • Hiring a professional to do it is costly, especially since its really supposed to be the owner’s plan, not the professional’s.
  • If completed, the plan sits on the shelf and is never referred to again so why go through the effort to begin with.
  • Why write it down? – I know what I want to accomplish.

What is the Purpose of a Business Plan?

Despite the factors why a business owner doesn’t have a written business plan, there are primarily two reasons to do so.

Someone outside the business wants to see it. This is probably the most common (and least useful) reason why a business plan is developed and usually the reason all those books on the subject exist. If the business owner (or prospective one) is looking to raise capital from a bank or investors, they are going to want to see a plan before they start spending their money. At a minimum, they are looking for assurance that the owners and management have thought the business through, and it has a reasonable chance of success that will provide an adequate rate of return for the lender or investor.

Typically, this type of business plan will cover things like:

  • The qualifications and experience of the owners and management (also known as an Executive Summary)
  • The mission, vision, and values of the business
  • Short- and long-term goals
  • Strengths and weaknesses of the owner and management
  • The legal and tax structure (Sole Proprietor, Partnership, Corporation, LLC)
  • A description of the business proposition and products and/or services to be offered
  • An analysis of the industry, competition, and the business environment in general
  • A customer profile
  • A detailed marketing plan including the results of any market research
  • Financial projections for several years
  • Plans for growing the business
  • An exit strategy

This is the type of business plan that quickly becomes a book. The larger the company or its aspirations, the more likely this will be the business plan written. 

The business plan is used internally to plan, direct, and control the business. This is probably the least common (and most useful) reason why a business plan is developed. It could include many or all of the items listed above, but the real purpose is for the business owner or manager to think critically about the business and its operation and develop projections and standards that can be compared to actual results on a periodic basis. Addressing the items above can be useful, in fact necessary, in doing this but there doesn’t need to be a formal presentation of them. A list of assumptions, maybe a page or two, based on the goals of the owner should be sufficient.

If variances from the projections and standards occur, action is taken quickly to determine why they occurred and what actions need to be taken to follow though on positive results and correct negative ones. 

The core of this type of business plan is a BUDGET.

A Simple Business Planning Strategy

Business planning doesn’t need to take on a life of its own. The following should be a simple but effective approach to the planning process.

  • Decide what type of business you want to have or to become. Most businesses can be broken down into the owner (1) creating a job for themselves or, (2) building a business that becomes separate from them and which can operate without them and be turned over or sold to someone else in the future. Either one is fine, and one can evolve into the other (usually from (1) to (2)) but figure this out and start your list of assumptions with it.
  • Write a brief description (a paragraph or two) describing the mission, the business proposition and the goals and keep it handy so that you can refer to it from time to time.
  • Create a BUDGET for at least two years on a month to month basis and annually for at least another 3 years (5 years in total). The budget process will force you to address some or all of the items listed above as part of a detailed business plan, but as you do, try to break them down into essential items that can be included on your list of assumptions. For example: 
    • What are you going to sell, when are you going to sell it, how much and at what price?  
    • What expenses do you anticipate and when will they occur?
    • How much do you need to take out of the business?
    • How much will you need to cover all of that (also known as capitalization)?
    • What are the projected taxes?
  • Make sure you have a proper set of books so that you can track your income and expense and be able to compare it to your budget.
  • Identify any variances and take corrective action if necessary.

To repeat, this type of business planning is used to Plan, Direct and Control your business. It can be written on a page or two, plus some spreadsheets for the BUDGET and will be easy to refer to and updated on a periodic basis.

Conclusion

Business planning for the day-to-day or month-to-month running of a business is essential and often overlooked or ignored. It doesn’t have to be a complicated process, but it can provide many benefits and help the business owner operate the business efficiently and profitably. Ideally, the planning process should be done by the owner or management and not by someone hired from outside the business.

However, a professional, such as a Certified Public Accountant (CPA) that specializes in small businesses can provide assistance in the planning process by analyzing the current finances of the business, asking the owner meaningful questions, assisting in the formatting of the BUDGET and making sure that a proper set of books are in place and up to date so that results can be compared to the budget and corrective action can be taken by the owner or management.  

Large companies have an employee called a Controller that handles much of the financial part of the planning process. Small businesses typically can’t afford that.  But a CPA can provide valuable assistance in this area to the business at a reasonable and affordable price.

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How the CARES Act May Affect Your Small Business

Congress recently passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. There are provisions in this 335-page bill that affect just about all Americans, both individuals, and businesses. There has been much information and speculation as to what is in the bill and this article will attempt to shed some light on the more important items that affect small businesses. 

The CARES Act is an example of the difference between a new law and what really happens.

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When Should My Business Hire a Controller?

At some point in their existence, a small business may face the decision about whether to hire a Controller. The timing of this will vary widely among businesses depending on their size, projected future growth, current staffing, and organization of the firm’s accounting function. It will also depend on what the business owner or management expects a Controller to do and what they can afford to pay for that position.

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Small Business Deductions – What to Write off on Your Taxes

Small business owners often wonder what they can deduct in their business. There is a perception that because you own a business, there are all sorts of tax write-offs (loopholes) that can be taken advantage of.  

This is true, to an extent. The tax laws do favor businesses in what they can write off compared to individual taxpayers. What is important to remember, though, is that these write-offs can be subject to the size and scope of the business in question. 

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How Do I Select a Tax Preparer?

Every year, as April 15th rolls around, there is a flurry of activity as most Americans seek to file their tax returns. There are many ways to get all those forms filled out and sent off to the Internal Revenue Service (IRS). You could do it yourself by filling in the form manually. You could also use one of the many popular tax software programs currently available, from the free to the very simple and inexpensive to the very complex and very expensive (remember you get what you pay for). You could also seek out a tax preparer who will fill out the forms for you and charge you for their services. 

But, as with the software programs, there are many options and skill levels available. And what about filing the return, should it be mailed or does it have to be filed electronically? Finally, what if you need to file an extension.

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Should My Business Be an S-Corporation

The choice of entity is one of the most important decisions a new business owner faces. Many new businesses are automatically set up as an S-Corporation as part of the overall formation process without any thought given to the potential risks or benefits of that selection, or for any other option also available.

The question of whether a company should elect S-Corporation status depends on several factors that will be explored in this article.

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How to Deduct Your Vehicle for Your Business


A number of my clients have inquired as to how to deal with their vehicle in their business. This is a somewhat complicated aspect of owning a business which I hope to clarify in this article.

The use of a vehicle is normally an ordinary and necessary expense of conducting business and, as such, is eligible for a deduction. In practice, there are a number of aspects to consider and, if they aren’t, the deduction may not be allowed.

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