A Startup Can Be Profitable And Still Run Out Of Cash—Here’s How

The difference between cash and profit is not subtle. Understanding the difference and planning ahead is essential to prevent financial disaster.

Photo: Dr. Al Davis, serial entrepreneur, lecturer and co-founder and CEO of Offtoa, Inc.; Source: Courtesy Photo
Photo: Dr. Al Davis, serial entrepreneur, lecturer and co-founder and CEO of Offtoa, Inc.; Source: Courtesy Photo

New entrepreneurs often confuse profit and cash. Understanding the difference can be critical to your success.

After all, it is possible for your company to be profitable and yet still run out of cash. It is even possible to be unprofitable and have plenty of cash.

Making a profit is one good indicator of whether or not your company is successful. Having cash determines whether the company will be alive (i.e., survive so it can be successful or unsuccessful). To help you understand the difference, let’s examine the two concepts.

 

Earning a Profit

Revenue (a.k.a sales) is what you record on your financial books when you sell a product or service to a customer. For example, if you sell a 2,000 bottles of wine for $25 each to customers during a month, you record $50,000 in revenues for that month.

If it cost you $10,000 to produce those bottles of wine (by the way, that’s called cost of goods sold) and you paid rent and salaries during the month of, say, $25,000 during that month, your profit for the month will be $15,000, (i.e., you subtract your cost of goods sold and expenses from revenues).

 

Cash Receipts

A company can gain cash in four ways. By receiving:

 

  • Payments from customers when you sell products and services.

  • Payments from lenders when you apply for a business loan.

  • Funds from investors.

  • Cash for selling fixed assets (which is rare for a startup).

 

A company can lose cash in a variety of ways when:

 

  • Making payments to suppliers (i.e., cost of goods sold or expenses)

  • Making payments to lenders on a business loan.

  • Repurchasing stock; by returning outstanding stock back to the treasury (which is rare for a startup).

  • Buying assets by paying cash for the purchase of fixed assets.

 

When Cash Exceeds Profit

Many scenarios can demonstrate how you can be unprofitable and yet have cash. Let’s look at some. In all of the following cases, assume at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

Cash exceeds profit if you:

 

  • Have negotiated “net 60” terms with suppliers, you will still owe them $35,000 and you will end up with $50,000 in the bank at the end of the month (even though you had a profit of just $15,000).

  • Took out a loan during the month of $40,000, you then end up with $55,000 in the bank at the end of the month.

  • Accepted an investment during the month of $200,000, you will end up with $215,000 in the bank at the end of the month.

 

In all these scenarios, your profit is $15,000, but your cash was quite different, specifically: $50,000, $55,000, and $215,000, respectively.

 

When Profit Exceeds Cash

Many scenarios can demonstrate how you can be profitable and have much less (or even no) cash. In all of the following cases, assume at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

Profit exceeds cash if:

 

  • 500 of those bottles were sold to a customer that had negotiated “net 30” terms with you, that customer will still owe you $12,500 by the end of the month (by the way, that’s called your accounts receivable). You will have only $2,500 in the bank at the end of the month (even though you had a profit of $15,000).

  • You still owed $1,000 to a cork supplier from a previous purchase you had made (by the way, that’s called your accounts payable) and decided to pay it this month, you will have just $14,000 in the bank at the end of the month (even though you had a profit of $15,000).

  • You decided to purchase a major piece of equipment for $10,000, you would be unable to subtract that amount from your revenues, but you would have to spend the cash. Thus you’d have just $5,000 in the bank at the end of the month (even though you had a profit of $15,000).

  • Your customers (who are businesses themselves) are having cash problems and delay their payments to you due to hard economic times. If half of your customers have failed to pay you by the end of the month, you will have $25,000 less than you expected. That means you will end up with a negative balance in your checking account, something that banks frown upon. Before long, you could be out of business.

 

In all of these cases, your profit is $15,000, but your cash was quite different, specifically: $2,500, $14,000, $5,000, and minus $10,000, respectively.

 

The difference between cash and profit is not subtle. Many companies have been forced out of business due to lack of cash even though they were profitable. Understanding the difference and planning ahead is essential to prevent financial disaster.

 

This article has been edited and condensed.

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is the co-founder and CEO of Offtoa, Inc., an Internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Dr. Davis has also founded or co-founded five other startups, including a software business acquired by IBM in 2003 and a company that went public in 1995, later acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003. Not all of his ventures have been so successful which allows him to be candid and knowledgeable about the highs and lows of being an entrepreneur. Connect with @Offtoa on Twitter.

 

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