Turning an idea into a successful business takes focus, a well-laid plan and a seemingly endless supply of hard work.
Entrepreneurs know this going in. What you may not have accounted for is that once the stars align, hard work starts getting noticed and a business takes off, increasing expenses and tighter margins may threaten to stymy further success.
Whether it's to replace a worn-out piece of equipment, purchase more space to expand an operation to meet consumer demand or simply preparing to cover short-term gaps in cash flow, there comes a time when a loan or investment may be in order.
To that end, it's worth getting familiar with a couple of metrics that lenders and investors turn toward so they can determine the strength of a business: Cash flow and profit.
Cash flow and profit
These two terms are often bandied about when it comes to discussions about financial viability and they can help shape important business decisions, including the best way to pursue growth. Simply put, profit is revenue minus expenses.
Cash flow refers to the inflows and outflows of cash for a business. When the company receives more cash than it gives out as payment, it's positive cash flow. When there's more money going out than coming in, that's negative cash flow.
Does one carry more weight? In an ideal world, both profit and cash flow would be in balance but that's simply not realistic. For example, it’s possible for a company to be both profitable on paper and have a negative cash flow. Negative cash flow could hamper your business's ability to pay its expenses, expand, and grow.
Many entrepreneurs have even found themselves facing bankruptcy as cash runs dry and unpaid bills stack up. If you have a huge net profit but your cash flow is negative for one, two or three months then you run the risk of closing shop.
This is why so many people in finance say "cash is king". That said, it’s also possible for a company with positive cash flow and increasing sales to fail to make a profit. This is a position many startups and scaling businesses also end up in.
Earning revenue does not always increase cash immediately, and incurring an expense does not always decrease cash immediately. These situations are oftentimes fluid and just a matter of timing. Luckily, lenders tend to take a long view.
How to juggle it all
Not all business owners are experienced borrowers. If you are new to business or someone who has just been heads down working for years, you are among those who eventually have to look for a loan.
Typically, unless you've gone to business school or you have an accounting degree you may not know whether or not you're bankable so it's a good idea to create a trusted support network.
A trusted financial consultant, accountant and lawyer are the triad of professionals that can keep a business in balance. Their alternate views ensure that no rock goes unturned when it comes to setting a business owner up for success.
To put their varying views in perspective here's a simple example: An accountant would look at a set of financial statements from a tax planning, tax optimization standpoint, a banker would look at it from how much money is available to truly available to repay a debt, and the lawyer would look for the best legal way to structure it.
For the most part, when it comes to a lending situation the lawyer wouldn't be involved, but everyone working together can ensure the best outcome.
Get familiar with your financial statements
Financial statements clearly lay out the health of a business. These include a cash flow statement, an income statement and a balance sheet.
- A balance sheet is a record of assets, equity and liabilities.
- An income statement is a record of the total income, against the expenses (that's cash and non cash) to give insight into a company's net profit or loss.
- The statement of cash flows shows how cash inflows and outflows measure against each other. Cash flows can be further divided into three sections:
Inflows and outflows from operating activities, like sales or paid-for raw materials.
Cash flows from investing activities which are sales, an increase of equipment, or even dividends received.
Cash flows from financing activities, like proceeds from a loan or paying down a loan.
Together, they provide more insight into a business, and offer a picture of how cash flow, profits, and revenue intertwine. They're also what a business advisor or consultant or anybody evaluating or assessing a business would be looking at. And don't worry, ultimately, lenders want to see their clients succeed and are able to account for real-world scenarios when they're making decisions. When business banking advisors or commercial banking advisors look at all the requisite paperwork for a loan, they're looking at a business owner's debt repayment ability.
They're going to take a reasonable view of how much a borrower can actually afford. Among other things when they actually take a look at net income, which is either a net profit or net loss, they almost always add back the depreciation because they know that's a non-cash expense that's not really affecting a client's ability to repay their debt.
They then adjust or normalize for that non tax expense which on paper may be a hefty expense for the business is added back to the pool of funds considered available to pay back the loan.
Get expert advice
Have questions about cash flow and profits as it relates to your business? We can help. Connect with your Business Banking Advisor or contact us today.