Your business is making a profit every month… Great!
Your books are closed, the Profit and Loss account shows a healthy net profit, but there isn’t spare cash in the bank account. So, where is it? Read on…
As your business grows, you have to invest more on hand inventory to meet the demand of your ever-increasing customers. Your profit may have been spent here. There are other common places to spend that profit.
This ‘profit use’ can be found when you understand your Balance Sheet. If you compare two balance sheets, say one month or one year to the previous, you can see how much added value there is in the business. The changes in any asset or any debt (liability) are uses of that cash.
Let’s start by looking at Accounts Receivable (AR) numbers. AR tends to grow in line with your business generally. As your customers increase so does the amount that they owe you. Most B2B businesses don’t operate on a purely cash basis, so you have to wait for the money to be processed through your customer’s system, before you can realize that money. The bigger your AR, the more you are operating as a bank for your customers. This is a very common use of cash and profit.
Next, let’s look at the Accounts Payable (AP) number. You’re good at paying your bills when they are due, so this number tells you about what you are spending out to ensure you have the stock or raw ingredients so you can satisfy your current and future customers. This also generally grows with a business. More established businesses negotiate longer terms for payment, and essentially use their vendors to keep more cash in the business longer. If your AP shrinks while business grows, this is another use of your profits.
Pro Tip: If you want to compare two different Balance Sheet dates, you can simply run a Statement of Cash Flow. The cash flow statement shows all the changes (and only the changes) between these AR, AP, inventory and liability amounts. This includes any movement in the closing bank balance. Seeing this asset position grow is a way to gauge the health of your business.