Your Business Can Be Profitable and Still Run Out of Money

Part B: Understand the Money

Profit tells you whether the work was worth doing. Cash tells you whether you can keep doing it.

Picture a contractor who completes a $30,000 project in January. When he closes out the job, the books show a $10,000 profit. By any measure, it was a good job. He priced it well, his crew did the work, and the customer is happy.

The customer does not pay until March.

In the meantime, the materials had to be bought in January. The crew had to be paid in January. Rent came due, and so did the advertising that brought the job in the first place. The business needed cash before the profitable sale produced any cash at all. So who is this contractor, in February, with a profitable job on the books and an empty account?

If you only remember one lesson from this part, make it this one. I would rather you understand it than memorize a dozen formulas, because running out of cash is a common reason healthy businesses get into trouble.

Walking through January to March

Let me make the numbers simple. These are made-up figures to show the pattern, and to keep it clean I am pretending this is the only job the business has. The job is $30,000 and, after every cost including materials, payroll, rent and advertising, the net profit is $10,000, so the costs of doing it are $20,000. Say the business starts January with $8,000 in the bank.

• January: the business starts with $8,000. Nothing comes in. Materials, payroll, rent and advertising total $20,000 and all of it is due. Ending cash: $8,000 minus $20,000, which is a shortfall of $12,000. Somebody has to fund that $12,000, and we will get to who in a second.
• February: still no payment. The work is done and the customer is happy, but the invoice is waiting. Cash received is zero, so the business is still $12,000 short at the end of the month.
• March: the customer pays $30,000. The shortfall of $12,000 is covered and what is left is $18,000. That is the original $8,000 plus the $10,000 profit.

Look at what happened. On paper the business earned $10,000 in January. In cash, it spent the whole first quarter unable to pay what it owed. Somebody covered that $12,000 gap, whether that was the owner’s savings, a supplier who waited, a credit card, or a crew that went unpaid. The profit was real, but it arrived two months after the bills did.

That difference is timing. Profit is counted when you earn the money. Cash is counted when the money moves. The gap between the two is where businesses get hurt.

Why growth makes it worse

Here is the part that surprises people. Growing often consumes cash, because you spend before you collect. Win two big jobs instead of one and you buy twice the materials and cover twice the payroll before either customer pays. The better you do at selling, the deeper the hole can get.

We see owners celebrate a record month and then struggle to make payroll the next week. Nothing was wrong with the work or the pricing. They were simply looking at profit and calling it cash.

We see this constantly with contractors. Money comes in, money goes out, and there is never anything left over to cover a Friday payroll when a customer pays late. The fix is a reserve, which we cover in Building a Cash Reserve. To narrow the timing gap itself, the lesson on Deposits, Payment Terms and Collecting Money Faster is where I would go.

Profit measures whether the work was worth doing. Cash flow measures whether the business can pay its bills when they are due. You need both, and they answer to different clocks.

Set it up this week

Open the 12-Month Cash-Flow Forecast spreadsheet on the Resources page and fill in four things for each of the next 12 months: the cash you have at the start of the month, the cash you expect to receive, the cash you expect to pay out, and the cash you will have at the end. The end of one month becomes the start of the next. Be honest about when customers actually pay, not when you invoice, and put payroll, rent, materials and advertising in the month they leave your account. Then find the first month where the ending number goes below zero. That is the month to plan for now, while you can still do something about it. The full method is in Building a 12-Month Cash-Flow Forecast.

Expect two to three hours the first time, mostly spent finding your real numbers and remembering how long customers really take to pay. After that, a monthly update takes about 30 minutes, and the spreadsheet is free.

If your biggest customer paid sixty days later than you expect, what would you not be able to pay?