Are you turning a profit but running out of cash?

Is your small business turning a profit, but running short on cash? This scenario is more common than you might think. 

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If your company is managing its cash flow ineffectively, even reaching the golden benchmark of profitability may not be enough to keep it afloat. This could be due to investing too much cash into new facilities, inventory, or any other assets that don’t immediately produce a return. 

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In this article, we’ll explore this disconnect between profitability and cash flow, and offer some solutions and new ways of thinking that may help your organization out of this predicament. 

Fun fact: Your cash flow is not your profitability

When some managers hear the term “profitability,” the initial thought might be a growing bank account. They similarly might think of their income statement. What many managers forget is that there are also cash movements in the business that are not reflected in the income statement. There is a natural disconnect between cash flow and operating profitability that generally stems from accounting rules. Things like capital raises, inventory purchases, real estate transactions, sales taxes, and other balance sheet activities impact cash without touching income statement profitability.

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Income statements are also known as “profit and loss” statements. Any activity that does not meet the profit or loss criteria would not show up on that statement, and would therefore impact overall profitability. Here are a few examples:

• Raising equity capital is not revenue. Instead, it increases the bank account balance and equity portion of the balance sheet. People are investing in the company, but not paying for products. Accounting rules treat cash injections from investments and loans as balance sheet activity because they are changes in the capital structure and net worth of the business.
• Purchasing inventory increases the assets on the balance sheet but decreases cash. Remember, only when inventory is sold does it affect Cost of Goods Sold (COGS) on the income statement. Purchasing inventory effectively transforms cash into another asset type, without impacting profitability directly.
• Purchasing equipment or real estate decreases cash, but increases the fixed assets or real estate holdings on the balance sheet. This simply trades one asset for another.

How can companies run out of cash while turning a profit

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Conceptually, understanding cash flow is straightforward. There are only two parts: inflows and outflows. Corporate bank accounts generally work the same as your personal bank account. You probably take home a paycheck (inflow) and have expenses such as food, rent, or utility bills (outflow). Companies have the same mechanics. They sell goods and services in exchange for cash and in turn spend money on rent, utilities, and payroll. While there are many complexities and moving parts to managing cash at larger scales, a simple example can illustrate the common disconnect between profitability and cash flow, and how you might start building planning frameworks for your own organization.

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First, you will need to understand that every company collects their sales a bit differently. Restaurants might receive funds into their bank accounts once per week after credit card transactions settle with their payment processor, while Consumer Packaged Goods (CPG) companies that sell products into grocery stores might have terms with distributors that cause them to receive slower payments, maybe every thirty days.

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Let’s use an ecommerce brand as an example. Say this business generates $1 million of online sales in December and doesn’t have any other income or expense activity. on December 1st, and the payment processor distributes cash every 14 days. The $1 million in cash would be available on December 14th. 

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Now, let’s say a piece of real estate was purchased for $1.5 million cash in December for a new factory that manufactures goods that are sold online. The cash balance at the end of December reflects $1 million received from the sale of goods, but $1.5 million was paid out for the piece of real estate. This reduces cash balance by $500,000. 

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If there are no other inflows or outflows to the bank, there would be a negative $500,000 of cash flow for the month of December. From a profit and loss perspective, accounting rules tell us this business earned $1 million in profit during the month of December. Real estate purchases are not generally expensed immediately on the income statement but are instead capitalized on the balance sheet. If the management team only looked at profitability as a measure of success, they’d overlook the negative impact on liquidity. 

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Take a moment to imagine if this same transaction was repeated each month moving forward. This business would essentially lose $500,000 in cash every month, while simultaneously making a $1 million per month profit. 

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Companies that deploy capital too quickly into investments that payback slower than the business’s ability to generate cash in the immediate term, put themselves at risk. If a multi-location restaurant group opens new locations every month, but each of those new locations operates at a loss for a time until it ramps up, the company might see continuous compression on their cash flow. This makes their tight cash position worse. Sure, they’ve expanded their overall footprint — and those newly minted locations might eventually be profitable — but if they open multiple new locations that initially operate at a loss too quickly, the company could be burning cash faster than their existing locations can earn it.

Good cash management produces long-term sustainability 

Startup companies that regularly raise capital to fund ambitious growth plans might have an increased risk of falling prey to the profitability-cash flow disconnect. Brands can be so motivated to invest freshly raised capital that they make big real estate deals, enter into aggressive leases, or undertake large research and development projects without first creating a cash management framework that stress-tests their decision-making or the potential outcomes of investment decisions. Implementing cash planning frameworks early on in the growth process can give management teams better clarity on runway, allow more informed investment decisions earlier in the process, and generally enable better stewardship of the capital that is raised.

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The harmonization between balance sheet investments and operating expenses is the key to long-term success. It is imperative that growing companies create a plan that consolidates all projected cash movements within the business. This will help them identify when cash could get tight and when the company might want to pull back on expenditures. It will also reveal opportunities when the company's cash balance might be large enough to make additional investments in the business. 

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Above all, a well-built cash planning framework can illustrate the overall sustainability of a business’s operations. Without a framework that helps synchronize all areas of a company’s cash inflows and outflows, a company could run out of cash and fail to ever see it coming.

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