I once did the books for a restaurant owner who kept confusing the bottom line of his profit & loss (P&L) statement with his actual cash flow. If he hadn't had someone looking over his shoulder, the results could have been disastrous.
There's a cautionary tale here for all small business owners. Please note: I've provided a simplified example here to illustrate my point.
Another Day Older and Deeper in Debt
To get his business started, the restaurant owner had taken out a business loan. He had also run up a lot of credit card debt early on, charging additional equipment and supplies so as not to burn through the loan too fast. There's nothing wrong with that per se; a lot of small businesses start out in debt.
Even though he no longer used the credit card, the restaurant owner still had to pay down the debt. All told, he was on the hook for about $10,000 a month between the loan and the credit card. Even so, he was keeping his head above water. In an average month, his P&L would show a profit of about $15,000.
That's when the confusion started. Time and again the owner would see that profit and want to write himself a check for, say, $10,000. And time and again I would have to explain that he couldn't do that. That's because the P&L only shows profits or losses for a given month and doesn't factor in any cash used to pay for balance sheet items, like long-term debts. Before he could write himself a check, the restaurant owner needed to subtract $10,000 (for his monthly debt obligation) from the $15,000.
So while his profit for the month was $15,000, his overall positive cash flow was only $5,000.
Getting with the Program
Fortunately for small business owners, accounting software has come a long way since then. (And if you aren't using accounting software, you need to join the 21st century!) Every type of accounting software can generate a cash flow statement. This — not your P&L — is what you should use to gauge the true health of your business.
Basically, the cash flow statement analyzes a handful of vital signs worded something like this, depending on the program:
- Net cash provided by operating activities
- Net cash used in investing activities
- Net cash used in financing activities
To determine cash flow, you start with No. 1 and add 2 and 3 (don't let the negative numbers confuse you — just keep adding them!).
Your cash flow should be a positive number. If it's positive, but still lower than you'd like, you need to do a deeper analysis. If it's negative, you need to address your financial situation immediately.
Our restaurant owner had two basic options for increasing cash flow beyond $5,000 a month:
- Increase revenue (difficult, considering he had only one modest-sized restaurant to work with).
- Cut expenses (the more practical avenue).
One thing he couldn't afford to do was to run his business as if his long-term debt didn't exist. That's why he needed to focus on his cash flow statement — not his P&L.