Cash is King.
This is an unchallenged fact.
Out of all the assets you have in your business, cash is arguably the most important one.
I just came back from a Xero roadshow over here in Hamilton on 22 October 2019 and there were some interesting numbers thrown about. My #onething that I took away was that only 52% of small businesses in NZ are cash-positive and that one of the biggest causes of business failure is poor cash flow management.
So today’s article will be talking about why cash is so important and how cash is different from profit.
Why is cash important?
I’ll keep it simple:
Cash is the most liquid form of asset you can ever own. Cash is used to literally pay for everything. Ever since currencies were invented and barter trading fell out of fashion, cash, in one form or another has been used as a means of exchanging value for products and services.
You quite literally cannot survive (in an economic sense) without Cash.
Also, let’s be honest, all those assets you buy for your business, you buy them in the hopes of generating more cash in the future, right?
The movement of cash is known in accounting-ese as ‘Cash Flow’ which is simplified in this elegant formula:
Cash Flow = All Cash inflows (Cash Sales, Cash from selling Fixed Assets, Cash from Debt and Equity) – All Cash Outflows (Cash spent on buying supplies, assets, paying off loans, etc)
Therefore, in this article, I would like to emphasise that:
Cash Flow is not the same as profit
Profit, if you can recall, is All your Income minus all your Expenses. Now, you could also recall that income and expenses are recorded on an accrual basis. Meaning that they are recorded in the time they are incurred, NOT the time they actually get paid out! If you don’t know what the accrual concept is, head on back here to find out more.
Furthermore, we have a few things called non-cash expenses. As the name implies, non-cash expenses are expenses which don’t use actual cash. The best example of non-cash expense is depreciation, which reflects the wear and tear of your fixed assets. You might have a van that costs $10,000 which depreciates by 10% every year so you record an expense of $1,000 every year for depreciation – but you ARE NOT paying any actual cash for this expense.
To top it all off, any cash that you spend on buying fixed assets (or Big-As Assets™ – as I like to call them) are not recorded as expenses. In accounting-ese we like to call them capital spending (or capital expenditure). Why capital? Because fixed assets are generally bought using a business’ capital (their debt and equity). So yeah, you might have spent $3,000 buying a sweet new laptop to run graphic design-y stuff but sorry bub, you can’t claim it as a business expense and no, it won’t reduce your profit amount.
Same goes for paying off loans. Say you have a $100,000 loan and you paid the bank $2,000 but out of that $2,000, $500 is for the interest. The $500 interest is an expense, but the remaining $1,500 is simply recorded against your loan and reduces its balance.
Which is a nice segue to my next point – you pay taxes on your profit and not your cash. This is very important because the friendly neighbourhood Taxperson doesn’t care if you have cash in your bank or not, they only care if you have made a profit or not.
So, to quickly summarise, here is:
Profit VS Cash Flow
- Profit is recorded on an accrual basis, Cash Flow is recorded on an actual basis, as in when the Cash ACTUALLY gets paid in to/ out of your business
- Profit includes non-cash expenses like depreciation. Cash flow only looks at ACTUAL cash spent.
- Cash Flow records any cash spent on buying fixed assets and paying off loans. Profit records depreciation on fixed assets and any interest you pay on your loans.
If you are an accounting student, congratulations for choosing this site. Now quit bugging your lecturer and answer that Goddamned Profit VS Cash Flow essay question for your mid-terms. And no, you may not plagiarise this site.
If you are a small business owner, consider yourself educated. Now quit bugging your accountant about why you have to pay so much taxes when you got no cash in bank. And no, buying that $60,000 pickup truck in cash wasn’t a very good idea.