Not Understanding the Relationship between Cash Flow and Net Income

Many times when I ask a business owner how much money they made last month they tell me that when the month began they had a certain sum (e.g. – $10,000) in the bank and when it ended they had a different sum (e.g. – $15,000) in the bank so the difference (in this case $5,000) must be their profit.

Unfortunately, in calculating this figure they didn’t consider the following questions:

• Do we track our finances on an accrual or cash basis?
• Did we tap into our line of credit?
• Did we pay down a loan?
• Did we pay all invoices during the month?
• Do we have any significant outstanding accounts receivable?

Many business owners are under the impression that as long as they have enough cash to pay their bills and their salary then everything must be going OK.

In some cases this could be close to the truth, but often this is an extremely inaccurate understanding of the financial health of the business. In fact, many businesses go bankrupt because they have a false sense of security due to a cash position that doesn’t reflect the actually profitability of their company.

So, how do you fix this situation?

There are a handful of different solutions, but I recommend the following – prepare monthly (or at least quarterly) financial statements (P&L, Balance Sheet and Cash Flow Statement) and understand how the 3 are related. If this seems like too much effort ask your accountant to provide you with a simple high level summary on a regular basis. If your accountant tells you that they couldn’t possible prepare this type of summary for you – get a new accountant.

• How profitable is your company?
• How healthy is your balance sheet?
• What does this mean to the long term future of your company?