Cash flow in business is extremely important, however many people entering a new business or indeed, that have existing businesses, do not understand the significance of this statement.
If you rely upon your accountant to put together your financial plans without understanding them, then this can lead to disaster. It is important to use an accountant but you must also understand every aspect of your business, especially when making forecasts.
The element that is not usually discussed is the true profitability of a business. There a couple of profit lines on a profit & loss sheet, one of significance is your EBITDA line, that is, Earnings Before Interest, Depreciation and Amortisation.
After this profit line comes Profit Before Tax and then Profit After Tax.
Many people believe that the business is there to pay themselves a wage, which is why we all buy a business in the first place. However, before you even consider putting in your own earnings it is important to see how your business can operate at EBITDA. Once you look at this line you will soon see what the business can actually afford to pay you.
Practical examples
Over the years, it has been a too-regular occurrence with my involvement in franchised organisations that a franchisee would say, ‘I need some help as my business is not producing me very much income’. When I reviewed the P&Ls of these businesses it was usually the case that they did not understand EBITDA and had not calculated their true profit. I would find all kinds of expenses in the P&L that actually did not reflect the true business expenses. They were actually part of their own income but they did not count it in that way.
I would find expense items like Grandma’s wages for childminding, a larger than acceptable motor vehicle or motor vehicle that was not necessary for the running of the company, an extra vehicle for the spouse, interest on a loan, repayment of a loan, an island holiday, home utility expenses, an extra computer for the business, dry cleaning and so on.
When I pulled these expenses out of their P&L, to their great surprise, they suddenly realised that they were actually earning more than they had realised. However, the response would often be closely following by statements along these lines of, ‘well I am entitled to a holiday, I need a car and someone has to look after the kids’.
To which I would respond that while that is all very nice to have, if your business does not produce enough income then you cannot expect it to pay you as well. This came as a big shock to many business owners and made them rethink their way forward.
The problem with these situations is that ‘the horse has bolted’, the right way would of course been to have worked this out before starting your business.
How to remedy
When looking at purchasing a business there are a couple of things that you can do to help you make a commercial purchase rather than an emotional one. Firstly you start off with your own personal lifestyle check, that is, a reality check on all your expenses to live, including holidays, cars, entertainment and wellbeing. Once you have arrived at your total net expenses for living and gross it up for tax, you then have a starting point.
The questions then are whether this business can afford to give me this lifestyle that I need and can it afford to fund a loan (if needed).
After my early years of helping SMEs I realised that there needed to be some kind of training in this regard so I set about creating a financial model that would separate out all of these expenses to show a true EBITDA on projections, this is a hybrid of a P&L and cash flow worksheet. Such a model can really help people to understand and train them on the significant difference of cash flow and true operating profit. So by training people to fully understand their own business financials they can then have a sanity check with their accountant and be able to discuss more wisely their business model.
A trade exchange can help improve your cash flow
The world is changing at an incredible pace owing to technology and consumer pressure. One very interesting development is the alternate ways to banking for various requirements including loans, payment systems and even storing your cash. But there are also ways now of trading without using cash, you can trade your own goods or services. We are not talking about direct contra and we are certainly not talking about the avoidance of tax. There are and have been for over many years companies that you can join as a member to trade your goods and services, online and/or in a network of like-minded businesses. The companies are known as ‘trade exchanges’. Simply put you can offer a small percentage of your business sales to the network to gain credit and then spend that credit amongst those businesses, thereby conserving cash and gaining a new customer.
These trade exchanges only work if you have spare capacity or excess stock and they are not the be all and end all, but they can certainly assist your cash flow.
As an example if a restaurant or hotel has empty seats or rooms and they want extra business, traditionally they may offer a discount to entice those extra customers. With a trade exchange however, you can offer the spare capacity to the network, receive the credit and spend the full amount on an expense for your business without offering any discount.
The trade exchange acts as a third party record keeper and monthly statements (like a bank) are generated so that all transactions are transparent and include VAT.
In summary, it is important to understand your business model. Cash flow is critical so don’t ignore it and leave it to your accountant. Take the time to understand your business and work with your accountant to ensure you are going achieve the outcome required.
If you want to assist your cash flow you could consider alternate ways of trading.
Philip Ciniglio is CEO of Bartercard.
Further reading on cash flow
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