Why you should check your cashflow
Posted on 17th December 2020
Did you know that 82% of small businesses fail because of problems with their cashflow?
We thought we would take a look at the difference between revenue, profit and cashflow to help explain why it’s so important for your business.
Revenue vs profit vs cashflow
Revenue is the income your business earns by selling goods and services and can also include income from other sources, such as interest, fees and royalties. We usually talk about revenue over a certain period, such as a month, a quarter or a year.
Normally, once you have issued an invoice, that amount will be counted as revenue, even if you haven’t received payment. Revenue also includes cash payments you have received in a month, for example.
The idea of revenue is useful if you want to compare your performance this year with the same quarter last year or if you want to know how much a customer is spending with you.
However, revenue doesn’t reflect how much you have spent in the same period.
Your profit is your revenue minus your costs and expenses. To make a profit your total invoices must be for more than it has cost you to run your business and provide your goods or services. There are two types of profit - gross profit and net profit.
Gross profit is your revenue minus the cost of those goods or services (COGS), which are the direct expenses needed to create them. Your net profit includes all your other business expenses, such as distribution, payroll, utilities and taxes.
Cashflow describes the amount and timing of payments you receive and the expenses that you pay. This tells you when money is actually received and when it is spent.
Fig 1: Understanding your business cashflow
In this example, payments of £25,000 during the quarter look healthy if you know it costs £15,000 to run your business for three months. However, your COGS were £16,000 in the same period, leaving you £6,000 out of pocket.
Even if you started the quarter with a balance in your bank account of £15,000 (enough to pay the costs of running your business for three months), if you had two consecutive quarters with similar cashflow figures your money would run out in the first month of the third quarter.
You might have invested in additional production costs in Month 2 for delivery on a contract in Month 4. However, if your terms for payment are 30 days but your customer doesn’t pay you for 60 or even 90 days, you will still have the same problem.
Here’s an example…
When you actively forecast your cashflow and keep a careful eye on your income and expenditure against your forecast you will be able to anticipate problems. This means you can negotiate terms with your customers, like part payments in advance, or you might decide not to go ahead with a contract.
One of our clients was very concerned when their contract with an important customer was due for review.
We looked at the overall business running costs and the costs of providing the service to their customer. Having taken account of staffing and administration costs specific to the contract our client realised that it wasn’t as profitable as it had appeared.
So, far from being tempted to reduce the contract value to keep the business, it was time for some careful consideration.
There’s an app for that
To fully understand the implications of different approaches to this contract for our client we used Floatapp, which is a really useful tool to give a real-time view of cashflow and to forecast the future financial position of your business.
We used the scenario planning tool to check what would happen in different situations, to compare the results with the past, and to create projections for the future.
If you have been struggling with spreadsheets to understand your business, you can copy and paste them straight into Floatapp and you can track your actual payments against your forecasts, so that there aren’t any unpleasant surprises.
Even better, it can be integrated with Xero and other accounting software so that you can see accurate information immediately. You can even see the bills you have to pay and can compare them against your projections.
If you would like to know more about cashflow forecasting, please get in touch.
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