What is the most important financial concept an entrepreneur should know?
Too many people think that cash flow is the same as profitable, which leads sometimes to dangerous complacency. True, they are related; but you can be profitable and run out of cash. Just being profitable isn’t enough to guarantee cash.
And by the way, cash and cash flow in this context refers to liquidity, money in the bank, not coins and bills.
But just tracking profit & loss, as most of us do, isn’t enough for most businesses. Here are 5 sticking points where money in the bank is different from what you see as Profit & Loss:
1. Every single dollar in Accounts Receivable (AR) is a dollar less in cash. AR is the standard for B2B business. You deliver the goods or service along with an invoice, and the client/customer pays you later. That money shows up as sales in the Profit & Loss, but it’s not in the bank; it’s in AR. This brings up AR aging, collection days, and a flock of related concepts that are all important because a business can die over failing to collect on AR – even profitable businesses choke on AR.
2. Every dollar in inventory is a dollar less in cash. As with money you have in AR, money spent on inventory doesn’t show up in the P&L until you sell the stuff and it becomes cost of goods sold. So whatever is in inventory isn’t in your bank account. As with AR, companies that are profitable in the P&L can run out of cash in the bank because they got their inventory constipated. In some extreme cases, expenses get misdirected to inventory, and the system clogs up with inventory that pretends to be assets and creates a fiction that ends up with the reality of no cash in the bank.
3. Every dollar in Accounts Payable (AP) is a dollar more in cash. Ideally, you finance inventory and AR with the money you owe to your vendors. You have to manage the pull between paying on time, paying late, and stretching AP without getting a reputation for late payments or a bad credit rating. It takes management.
4. Debt repayment doesn’t show up in P&L. It costs you money, but you won’t see it if you don’t track cash flow. The interest portion of payments is an expense, so that shows, but principal – debt repayment – doesn’t show up. You have to watch and plan for it.
5. Buying assets doesn’t show up in P&L. It takes money to buy your assets (equipment, plant, land, furniture, etc.) but those don’t count as expenses, so you don’t see them in P&L.
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And I second existing answers (to the Quora question) that include fixed vs. variable costs, because the trade-offs come up often and matter a lot, and this area is full of choices you can make. Do you hire the person as an employee or contract out for skills? Fixed costs are generally lower than variable costs, but they also increase the risk.
I also second the mention of sunk costs. That is an important concept too, and not intuitive. We so often think we have to continue down some path because we’ve already spent so much money on it. It’s hard to let that go. But the money already spent is a sunk cost. You don’t get it back by spending more. So decide based on whatever decision criteria make sense, in a specific situation; money already spent is never a good reason, by itself, to spend more.
This article was originally written on July 8, 2015 and updated on November 3, 2016.
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