Profit is crucial to success. But net profit, as reported in your profit-and-loss statement, fails to address a critical issue for small businesses — timing. Here’s a look at why the bottom line won’t necessarily get your bills paid, and why cash is always king.

Net Profit Versus Cash Profit

Most small business owners understand the basic concept of net profit. It’s calculated by subtracting all your expenses from your gross revenue over a reporting period, typically a quarter or a year.

What about the lesser-known concept of cash profit? Under this calculation, revenues are based solely on cash receipts and expenses solely on cash payments. “Profit” is the amount you have after deducting inventory purchases from cash received from sales. By excluding unpaid invoices, cash profit places heavy focus on working capital —the cash you need to finance your day-to-day operations. Let’s look at an example:

Sam’s Computer Shop

Suppose Sam makes $80,000 in September selling computers to businesses. The computers cost $35,000 to purchase and Sam’s operating expenses are $15,000 for the month. Thus, Sam made a net profit of $30,000 in September.

But since Sam gives his customers 30-day payment terms, by the end of September he has only collected $60,000 of his $80,000 in invoices. Looking forward, November is a good month for technology sales, and Sam thinks he can make $120,000 if he purchases $52,000 worth of inventory. It takes around six weeks to get this additional inventory delivered, so he orders and pays his supplier $52,000 in September.

However, the problem is that Sam now has only $8,000 left to cover his operating expenses. Thus, even though Sam made a $30,000 net profit in September, he suffered a cash loss of $7,000.

Cash Profit and Working Capital

Cash profit identifies when a business needs money. It is essentially a measure of current assets versus current liabilities, or how much cash a business needs on hand to keep it running and investing in growth.

In Sam’s business, he needed to invest $37,000 in working capital to keep the business going and growing. This is made up of $20,000 accounts receivable and $17,000 in additional inventory costs. Unless Sam can quickly find this money, he will go under. From this example you can see that net profit and cash profit don’t always match up — and even if you are profitable, cash really is king.

Improving Working Capital

There are numerous ways to improve working capital and balance out cash flow. These include:

  • Reducing inventory hold.
  • Shortening payment terms.
  • Vigorously chasing accounts receivable.
  • Securing credit terms with vendors and suppliers.
  • Small business loans and flexible lines of credit.

Without the above-mentioned channels to make up a cash deficit, a business can go under even though it is profitable. This is hard to swallow, but it happens daily in businesses, and makes a strong and immediate case for putting the spotlight on cash.