Making Money

Q. I have a business which I think is doing well. My accountant says it’s profitable. Unfortunately, I never seem to have any cash. Further, I took out a $150,000 second mortgage line on my home to start the business. While I have made interest payments, I haven’t been able to pay down the balance at all. Was this a good investment? Am I really making money? How can I get a handle on my financial position?

A. The answer lies in understanding the differences between profit, cash flow and Return on Investment (ROI). Given the disparity between profit and cash flow you described, we are going to assume that you are using an accrual based accounting system. This is typically the best system to use for management decision making and understanding the financial health of your business on a month-to-month basis because it matches revenue to the expense that generated it.

Your accountant says you are profitable. This means that the number on the bottom of your income statement is positive—the revenue you recognize each month exceeds the expenses that generated that revenue. This is good. However, it does not necessarily mean that you have positive cash flow. Your business may be very profitable, but if your inventory, accounts receivable and/or fixed assets are growing rapidly, it may not have a positive cash flow. Growing these three accounts uses cash. For example, you have to spend cash to buy inventory. However, these are all balance sheet accounts that do not immediately affect the income statement. Therefore, they have no impact on profitability.

It is absolutely possible for a business to be profitable and hemorrhaging cash at the same time. The fact that you never seem to have cash and haven’t been able to pay down the balance on your loan indicates that you may have cash flow issues. We suggest that you ask your accountant to analyze your monthly cash flow over the past couple of years. It is possible that your cash is being spent to grow assets. If this isn’t the case, we suggest that you have an independent third party do a thorough check for embezzlement. We’ve seen thieves pull amazing stunts to make the books look right on the surface while they siphon cash out of the business.

It is possible to have a profitable business and even have a positive cash flow, but not be getting a good ROI. You initially funded your enterprise with a $150,000 investment (we’re assuming that you didn’t put any other cash into your business). Let’s assume your annual profit is $1,500 and that this is also your cash flow. ROI is calculated as Profit divided by the Investment. In this case the ROI would be 1%—not an impressive performance. At this rate, it would take 100 years to earn back your investment. Depending on the specifics of your situation, you should target at least a 10% to 20% return on your investment.

To return to your initial question, you are making money if your business is profitable. The next question is, how profitable is your business? This is often measured by Return on Sales (ROS) which is calculated as Profit divided by Sales. The appropriate ROS target is a function of your specific situation, but for many businesses a 10% ROS is a good target (obviously, more is better).

Once you understand your profitability, make sure that this translates into an acceptable positive cash flow. As a finance expert told us, “You can’t buy beer with profit, you can only buy beer with cash.”

Finally, make sure that your ROI is acceptable. If you are achieving your target ROS, but you still aren’t getting the ROI that you need, the answer is likely that you need to grow your sales without making additional investment. In other words, you need to improve your asset utilization (sometimes expressed as sales divided by assets).

Assessing the financial health of your business is not a one dimensional exercise. However, if your ROS is acceptable, your profit is translating into cash flow and you have a good ROI you can rest assured that the financial health of your business is good.