We have discussed revenue and profit drivers so it’s time to discuss the third and final set of drivers you need to understand to manage your business – cash flow drivers. These are possibly the most important to survival.

If you missed our article on the revenue drivers, click here.

If you missed our article on the profit drivers, click here.

By the end of this article you will understand:

1. Why profit is not the same as cash flow and why you need to understand cash flow.

2. The 5 key drivers which cause your bank account to go up and down each month, helping you understand cash flow.

3. How to apply the drivers to understand why cash went from X to Y

Here’s something interesting to think about…

Profitable companies can go out of business.

Unprofitable companies can stay in business. (Looking at you Airbnb, Uber and Peloton)

Why? The answer is, cash – because profit does not equal cash flow.

Here’s a brief explanation of the difference between profit and cash flow. If you understand this, just jump down to the heading called “The 5 Cash Flow Drivers” or click here.

Profit is simply your revenue minus expenses.

Cash flow takes into account the timing and management of your revenue, expenses and other cash items not reflected in your profit. Once you make profit you still have to do things like collect on your sales, buy inventory, pay bills, pay debt payments, take money for taxes, etc. These are what we call cash flow drivers and we lump them into 5 simple buckets.

In a simple world, if you make $10,000 in profit, your cash increases $10,000 at the same time. This is what I call lemonade stand math. You buy your lemons in the morning, you make lemonade that day, you sell it and customers pay you on the spot and then you pay your friends and walk home with your profit. All the cash transactions occurred that day. In this case, profit equals cash flow.

Unfortunately that’s not how most businesses work – it’s more like this:

You provide a product or service today, using supplies you purchased 3 months ago, using employees you will pay in two weeks and a contractor you already paid, and hope to get paid in the next 30-60 days from the customer while you need to take money out of the business to make those quarterly tax payments. That’s a mess. There’s cash flowing in and out everywhere and none of it matches your profit for the month.

If you don’t have an understanding of why cash is moving, you can’t control it to optimize the flow in your favor.

This is why understanding cash flow becomes critical!

Failing to understand and manage cash flow is how you run out of cash, especially during growth. Fun fact: You can grow yourself out of business if you’re not aware of how cash flow works. (More on that later.)

I think I’ve sold you on this concept enough to keep reading. Let’s move on to the cash flow drivers.

The 5 Cash Flow Drivers.

There are 5 key numbers to track and monitor for cash flow.

First, while it’s not a driver, your net profit (with depreciation expense added back) is where we start with your cash flow. If you made $10,000 in profit, the top of your cash flow equation is $10,000. Let’s move on to the drivers behind why your cash doesn’t equal profit. You can think of these as ‘adjustments’ to net profit. There’s a formula at the end to help this make more sense.

Driver 1 – Accounts Receivable (A/R)

This is how much your customers owe you from sales you’ve made to them.

If the amount customers owe you increases, your cash goes down.

If the amount customers owe you decreases, your cash goes up.

A business must be prepared to have a larger amount of cash not received as their sales grow, unless they can find ways to shorten the amount of time between providing the product/service and getting paid.

For example, if you’re a $1M revenue business trying to grow to $3M and it takes 40 days to receive payment on average, you will have about $222,000 of cash tied up in your increase in A/R as you grow…meaning $222,000 of your profit is not in your bank account until a later time!

Driver 2 – Inventory

This is how much cash is currently ‘tied up’ in goods/supplies you will use for resale or providing your service.

When you buy inventory, your cash goes down.

When you sell inventory, your cash goes up.

If your business requires inventory you have to be mindful of variables like inventory lead times, vendor payment terms, how long it sits in inventory before selling, etc. All of these variables will impact the cash flow in and out due to inventory.

I mentioned a business can grow itself out of business, here’s how: If the same $1M company is growing to $3M and they require 90 days of inventory sitting on hand due to lead times, and have 50% gross profit, they’ll need $250,000 of cash to help them meet their inventory purchasing demands as they grow. (Driver #4, debt, comes in handy in managing this challenge.)

Driver 3 – Assets

This is how much cash is required to buy tangible and intangible items the business needs to operate. This is pretty straight-forward.

When you buy assets with cash, cash goes down.

When you sell assets and receive cash, cash goes up. (This is rare for most small businesses.)

Assets could be computers, machinery, trucks, etc.

The next driver can help manage cash flow to reduce how much goes out for purchasing assets…

Driver 4 – Debt

This is how much cash is borrowed for use in the business. It could be to fund inventory or asset purchases or to provide additional cash to fund the day-to-day operations during a ‘cash crunch’.

When you borrow new debt (take money or ‘use’ debt), cash goes up.

When you pay back debt, cash goes down.

A word of caution: One of the biggest mistakes we see with the use of debt is to fund an unprofitable business when there’s no plan to fix it. Sometimes businesses will use debt as a way to finance a start-up period or periods of heavy growth – that’s not what we’re talking about right now. We are talking about taking loans or lines of credit to make up for lack of cash flow due to struggling with profitability. If this is you, let’s talk.

A ‘smart’ use of debt is establishing lines of credit or payment terms to help fund the purchase of assets or inventory required to generate profits.

This is how you can shorten the time between when you get paid and when you have to pay vendors/suppliers/payroll.

Proper use of debt can even help you establish a positive cash conversion cycle, which is the number of days between paying suppliers and receiving cash from sales. (In a prior life, our team had a cash conversion cycle of +25 days at one point, meaning we received cash 25 days ahead of having to pay our suppliers…woo!)

Driver 5 – Owner Investment or Distributions

This is the amount of cash an owner puts in or takes out of the business.

It probably doesn’t have to be said, but when an owner puts money in, cash goes up.

When an owner takes money out, cash goes down.

Back to those companies who can stay in business while not profitable, it’s because their owners are giving the company money (as investments) to fund a current lack of profit and the other cash flow drivers while the company grows.

The Formula and an Example

Now that we’ve reviewed the 5 cash flow drivers (reasons why your cash changes) let’s look at the formula to give you some context and drive the point home. This is a real customer example.

Here’s what you can see using these drivers:

First, the business made $49K in profit for the month.

Their A/R increased by $8,839 so that’s less cash in their bank account. Cash went down.

They purchased some equipment needed to operate their business and used $4,683 in cash. Cash went down some more.

Finally, due to equipment loan payments and paying down December debt/accounts payable, they had $36,897 leave their bank account. Cash went down even more.

The result here is a net reduction in cash by $868 after they made $49,551 in profit!

Stay alive and thrive!

Businesses survive and thrive because they have cash. 

We don’t want you to get caught with your guard down because you’re profitable. Unless you’re running the lemonade stand, you need to be aware of your cash flow and how to improve it. 

Even if you don’t have the ability to track these drivers by the numbers each month, having this basic understanding should help you focus on the areas where you can work to ensure cash is coming in at a greater rate than it’s going out, as much as possible.

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