Profit vs cash flow: why profitable small businesses still run out of cash
A small business can show a profit and still be unable to pay its bills. Here is how receivables, inventory, loan payments and taxes open a gap between profit and cash, and how to manage it.
One of the most common reasons small businesses get into trouble is not a lack of customers or a bad product. It is running out of cash while the books say the business is making money. Profit and cash are related, but they measure different things, and the gap between them can be large enough to sink a company that is otherwise doing well.
Two ways of counting
Under cash-basis accounting, you record income when money arrives and expenses when you pay them. Under accrual accounting, you record income when you earn it, for example when you deliver the goods or complete the job, and expenses when you incur them, whether or not money has changed hands. The IRS allows many small businesses to use the cash method, but larger businesses and those with significant inventory are often required or choose to use accrual accounting, and lenders and investors generally expect accrual statements.
Accrual profit gives a truer picture of whether the business model works. But it can hide the timing of cash, and timing is what determines whether payroll clears on Friday.
Where profit and cash part ways
Customers who pay late. If you invoice a customer on 30- or 60-day terms, the sale counts as revenue now, but the cash arrives later, if at all. A fast-growing business that sells on credit can find that the faster it grows, the more cash is tied up in unpaid invoices (accounts receivable).
Inventory. Money spent on stock sitting on shelves or in a warehouse is not an expense on the profit and loss statement until the goods are sold. Buying ahead for a busy season, or taking a bulk discount, can drain the bank account while profit looks unchanged.
Loan principal. Only the interest on a loan is an expense. The principal portion of each payment reduces the loan balance but does not appear on the income statement. A business can be profitable on paper and still struggle to meet its loan payments.
Equipment and other capital purchases. A new van or machine is usually recorded as an asset and expensed gradually through depreciation. The cash, however, leaves in one go, or through financing payments.
Taxes. Tax is owed on profit, not on cash in the bank. A business with rising receivables can owe tax on income it has not yet collected. Estimated tax payments are due quarterly for many owners, which can arrive at awkward moments.
Owner draws. In sole proprietorships and partnerships, money the owner takes out is not a business expense, so it does not reduce profit, but it certainly reduces cash.
The cash conversion cycle
A useful way to see the problem is the cash conversion cycle: how many days it takes to turn money spent on inventory and labor back into cash from customers. It is roughly the days it takes to sell inventory, plus the days customers take to pay, minus the days you take to pay your own suppliers. A business that pays suppliers in 15 days, holds stock for 45 days and collects from customers in 45 days has about 75 days of operations to finance before it sees the cash. Shortening any piece of that cycle frees up money.
Practical ways to close the gap
- Invoice promptly and follow up. Send invoices the day work is done, make payment easy (card, bank transfer, online links) and have a routine for chasing overdue accounts.
- Review payment terms. Ask for deposits on large jobs, consider small discounts for early payment, and check whether your terms are longer than your industry's norm.
- Negotiate with suppliers. Longer payment terms from suppliers can offset slower-paying customers.
- Keep inventory lean. Track which items sell and which sit. Slow-moving stock is cash you cannot use.
- Set aside tax money in a separate account as revenue comes in, rather than finding the money when the bill is due.
- Arrange a line of credit before you need it. Lenders are more willing to extend credit to a business that is not in immediate difficulty. Use it for timing gaps, not to cover ongoing losses.
Build a simple cash forecast
A thirteen-week cash flow forecast is a common tool for businesses of any size. List your opening bank balance, then for each week the cash you realistically expect to receive (based on when customers actually pay, not when invoices are due) and the cash you must pay out: payroll, rent, suppliers, loan payments, taxes and owner draws. The running balance shows, weeks in advance, when you might run short, which gives you time to chase receivables, delay a purchase or talk to your bank.
Update the forecast weekly against what actually happened. Over time, it becomes more accurate and teaches you the rhythm of your business: which months are tight, which customers are slow and how much cushion you need.
Read all three statements
The profit and loss statement tells you whether the business makes money over time. The balance sheet tells you what it owns and owes at a moment in time, including receivables, inventory and debt. The cash flow statement reconciles the two with the change in your bank balance. Many small-business owners look only at the first. Looking at all three once a month is one of the simplest ways to avoid a cash surprise.
The bottom line
Profit tells you whether the business works. Cash tells you whether it survives long enough to prove it. Managing receivables, inventory, debt payments and taxes with a regular cash forecast keeps the two from drifting dangerously apart.
This article is general information, not accounting or tax advice. A qualified accountant can help with your specific situation.