How is it possible to have high sales and high profits and run out of cash?
Is it possible for a firm to run out of cash even though it is profitable?
Simply because a company is profitable, doesn’t mean it cannot run out of cash. So how is it possible to have high sales and high profits and run out of cash? Let’s take a look…
How is it possible to have high sales and high profits and run out of cash in 15 seconds…
How is it possible to have high sales and high profits and run out of cash is pure and simple: If your business fails to convert business sales into profits, but more importantly into cash-profits, the business will fast run out of cash and could even fail.
What’s the difference between sales and cash?
It’s worth starting with the old adage ‘turnover is vanity, cash is king‘. This is always the case, because no matter how high your business turnover (or sales) is, unless it’s turned into profits, but more importantly into cash, it will not survive for long. Cash is the life-blood of any business.
For a business to work properly, customer sales need to be paid promptly. But each sale made must be profitable too. That is, the difference between how much the product or service is sold to the customer for must be more than what it costs to make or to provide the service.
But also, the amount of profit made on each sale must be at a level that when you combine all the sales made by the business, the combined total profit must be sufficient to cover the total overheads and running costs of the business.
Also, it’s important for a cash-flow-rich company to have cash inflows from customers and the like to be coming in faster than the cash outflows to suppliers, wages and other business running costs.
What’s the difference between profit and cash?
It’s important to also highlight the difference between profit and cash.
- Profit is the money that is earned in a trade or business and is calculated after paying the costs of producing and selling goods or services, and after paying the overheads and other running costs; plus after taking off any taxes paid.
- Whilst cash typically refers to money in your hand, the term can also be used to indicate money in your business bank account too. So the term cash is a generic business term that refers to any business assets or forms of currency that can quickly be converted into physical cash and is usually easily accessible.
Why is profit not the same as cash?
As explained above, profit is essentially the difference between what a product or service is sold for (i.e. not necessarily paid for by customers), less what it costs to produce the item or deliver the service (but also, not necessarily paid for by the business). Therefore, just because a business is making a profit, this doesn’t necessarily mean this is being turned into cash.
All businesses need to have an effective cash management and collections process in place. Having a collections team will make sure that customers are appropriately chased for payment of the invoices they receive.
Other reasons for profitable businesses running out of cash
There are other reasons why a profitable business with high sales can run out of cash, these include the following:
- Stock piling: If the business is carrying high levels of stock, this will mean that a large amount of cash is tied up in the stock.
- Significant bad debts: If a business sustains a significant bad debt, i.e. one of its customers goes into liquidation owing money, then this can damage the amount of cash held.
- Over-trading: A business that is defined as overtrading, is one where the sales are increasing faster than the cash is being received. A business that over-trades will very fast run out of working capital.
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