Read most news reports and business articles and you’d think profits were the sole determinant of business success. But in my experience, regardless of headline profit numbers, running out of cash is the number one reason startups fail. In fact, the distinction between profits and cash can be significant, and if they diverge too widely spell the difference between success and failure.
Here’s a quick primer on these two terms: what they represent, and why you need to closely monitor and effectively manage both.
Profits are a measure of earnings and business efficiency.
What do we mean when we talk about profits? It’s a good question to ask, because there are different types of profit: gross profit/income, operating profit/income, and net profit/income.
- Gross profit is simply your sales revenue minus the cost of goods sold (COGS). The specific items that make up your COGS vary based on your industry, but might include software development costs, shipping, and other costs directly related to producing your product or offering your service.
- Operating profit is sometimes called EBIT. You can calculate this by subtracting general and administrative expenses from Gross Profit, then adding back interest. This is one of the numbers lenders use to determine how much debt you can service.
- Net profit is operating profit minus tax expense plus or minus any gains or losses (these could be from sales, inventory write downs, or intangibles).Net profit, more commonly called net income, is the figure equity analysts and investors use when talking about P/E ratios.
Cash Flow is a measure of liquidity.
Your startup cash flow statement is where you capture transactions that resulted in cash being generated or disbursed. Your operating cash flow number represents the cash you actually have available to meet your obligations.
To calculate that number, start with net income, then record all the subtractions or additions that impact it to arrive at a figure for your cash flow from operations. The most common subtractions are for Accounts Payable (what you owe), payroll, interest payments (if you’ve taken out debt), and taxes. Accounts Receivables reflects inflows from customer payments. Depreciation is added back because it is a non-cash expense that doesn’t reflect cash going out the door.
Preparing your financials isn’t always straight-forward and you may find you need help to get started, but the process of creating and regularly revising your financial forecasts gives you valuable information that you can use to improve your business model. The more iterations you go through, the more second nature it’ll become.
Now that you know the distinction between cash flow and revenue, here’s how you can take steps to tighten the link between the two:
- Closely monitor and manage your burn rate—and know your break-even point. Go through your accounts payable and identify where you can more efficiently manage expenses, especially for non-core activities. And make sure you’re on top of customer receivables. Top-line, aka revenue, growth is great, but you need to actually collect (with as little lag as possible) in order to stay in business, especially if your revenue model is subscription-based with large upfront customer acquisition costs.
- On the revenue side, make sure that your offering is priced appropriately for the market.
- On the cost side, look at whether you have the right mix of fixed versus variable costs and whether you’re paying reasonable rates for things like office space, staff costs, and/or development costs.
Do you have questions about cash flow versus profits? Ask us in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.