That may sound like a remedial question. Strict accounting guidelines are in place. While there are exceptions (Enron comes to mind), publically held companies accurately report their profits on a regular basis. Accounting standards are well established. Yet, for many small, privately held companies the answer to this question is less clear.
Profit versus Owner’s Compensation
One thing that causes confusion regarding the profit of many small businesses is the owner’s compensation. When asked how much money his business made last year one entrepreneur responded, “$50,000.” It turned out that this wasn’t quite accurate. The owner had taken $50,000 out of the business in the prior year—that was his compensation. However, hiring a person to do the work that the owner had done in the previous year would have cost at least $75,000. So, had the owner compensated himself at market rates, the business would have lost $25,000.
Accurately assessing the profit made by a privately held business requires adding retained earnings to all of the owner’s compensation (i.e., salary, bonus, commissions, dividends, benefits such as company cars, etc.). From this number, subtract the full market rate cost of an employee who could perform the work done by the owner. The remainder is the profit made by the business.
Profit Doesn’t Equal Cash Flow
For many small businesses, the owner is much more concerned about cash flow than profit. When asked what numbers they use to run their business, many entrepreneurs with whom we spoke pointed to the balance in their checking account—that’s cash flow. It’s wise for small businesses to keep a tight handle on their cash flow. As a well-respected accounting professor once told me, “You can’t buy beer with profits, you can only buy beer with cash.”
But, profit doesn’t always equal cash flow and many profitable companies have gone bankrupt. Consider the case of one distribution business. Gross profit is 40% of sales and net income is 10% of sales. The business has to maintain inventory to enable timely shipments to its customers. Its inventory turns four times per year. The business offers net 30 day terms. But, the average customer stretches this a bit and pays in 45 days. The distributor has to pay its suppliers in 30 days.
If the company’s balance sheet ratios remain unchanged, the cash flow implications of a dollar of sales growth in the current year are as follows:
Item Cash Flow Effect *
Increase in Net Income +$0.10
Increase in Accounts Payable +$0.05
Increase in Inventory -$0.15
Increase in Accounts Receivable -$0.12
The net of this arithmetic is the counter intuitive result that a dollar of sales growth increases profit by $0.10, but does not increase cash flow in the first year. On the contrary, it uses $0.12 of cash. The implication is that a successful push to grow revenue that results in a $1 million sales increase this year would actually result in the company having $120,000 less cash than if sales had stayed flat. That’s more than enough to bankrupt many small companies. A truly profitable business will eventually throw off cash, but it is important not to confuse profit with cash flow in the short term.
* * *
A small business owner can never lose sight of cash flow. Doing so can be disastrous. At the same time, accurately assessing the profitability of a small, privately held company can be tricky business, but correctly doing so will help the owner to understand how the enterprise is really performing and improve the quality of management decisions.
* For details on these calculations, please contact the author.