A cash flow forecast tracks cash flowing in and out of your business. The timing of these flows enables you to identify cash-rich and cash-lean periods and helps in making the right decisions, such as when to buy assets or when to prepare for cash shortfalls.
A definition of profit
Profit is the money left in your business after all your expenses have been paid. An income statement (also referred to as a profit and loss report) reveals what profit your business made last month or last quarter. Your profit’s detailed in two figures, namely:
- Gross profit – what’s left from sales after deducting the costs of goods sold or services provided.
- Net profit – what’s left from gross profit after operating costs (your business overhead expenses) have been deducted. This is the figure you are taxed on.
Note that net profit still isn’t the final ‘bottom line’ profit until all taxes have been paid.
Why cash flow and profit can differ
The gap between the cash in your business and the profit you report at the end of the year will (almost) always be different, as some of the things you buy with cash are not fully deducted in the profit and loss account.
Cash flow in that’s not counted as revenue on the income statement
A cash flow forecast records actual cash transactions over the year and can include items other than sales, such as:
- Capital injections by the owner or investors.
- Money you’ve borrowed.
- Cash from selling assets.
These sources of cash can help fund your business, but they don’t add to your end of year profit, as they’re not related to revenue. If you put $100,000 of your savings into your business bank account but didn’t actually start selling products or services and so had $0 sales, your cash flow would be plus $100,000, but your profit would be $0.
Cash flow “out” that’s not fully counted as an expense on the income statement
Sometimes you can’t count an outgoing payment or “money out” as an expense on your income statement or “profit and loss”, either. Here are three examples of cash outflows that are not immediately represented as “expenses” on your income statement or “profit and loss”:
- Owner withdrawals from the business are not counted as ‘expenses’ on the income statement. To be counted as an expense, you’d have to classify payments to yourself as a wage or salary.
- When you buy any significant assets, the amounts of the purchases leave your checking account (cash outflow). However, instead of deducting the full purchase price as an expense on the income statement in the purchase year, you might recognize only a portion of the purchase price as “depreciation” expense on the income statement. For example, if you bought a $10,000 asset and it should last 10 years, then (if you’re using “straight-line depreciation”), you’d count only 10%, $1,000, as an expense in year one (which you’d repeat for the next nine years until the asset were fully ‘depreciated’).
- An increase in inventory or raw materials. Your payments to suppliers are cash outflows but you don’t recognize them as “expenses” on the income statement when you pay the suppliers. At the end of each year, you only include as an expense the amounts representing product “used up” or “sold” during the year.
These scenarios help explain the gap between cash flow and profit.
Sales are great, so we must be profitable
Inexperienced business owners can easily confuse ‘being busy’ with being profitable, but there’s a very clear distinction between them. Your profit is always what’s left after all costs have been deducted.
If you haven’t calculated your selling prices correctly, your ‘thriving’ business may in fact be operating at a loss. The cash flow may seem great, but the profit and loss account reveals the true picture.
The critical lesson here is to never set your prices until you know all the costs involved. You might end up operating at a loss or at an unsustainably small profit level.
We’ve made many profitable sales but can’t pay our bills
It’s quite possible to run out of cash or go bankrupt by taking on too much business too quickly, even though each sale is profitable. This is called overtrading – and businesses that sell on credit rather than cash terms are more at risk.
Actions that can lower cash flow
Reasons businesses can run out of cash include:
- Excessive withdrawals by the owner(s).
- Purchasing too much inventory relative to sales.
- Taking on more loans than the business can service.
- Buying assets at inappropriate times (such as during a slow period).
- Prepayments or paying suppliers too soon. If suppliers offer 30 days, it makes sense to take advantage of the full credit period.