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Profitable and Out of Business

Profitable and Out of Business

By Tim Berry, Guest Blogger
Published: October 28, 2014 Updated: October 28, 2014

Having cash on hand is critical to staying afloat. In fact, profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health. Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash, as well as profits.

A simple example

One of the best ways to understand the cash vs. profits dilemma is to follow an otherwise-profitable company going broke because it can’t meet its obligations. Let’s do it with numbers, simple bookkeeping.

In the beginning

Start with $100 as startup capital. In finance and accounting, assets must always be equal to capital plus liabilities, so our initial balance sheet (not shown) would have assets of $100—the money—and capital of $100.

Sell a Widget

We buy a widget for $100 and sell it for $150. The simple bookkeeping illustration here below shows what happens. We have $50 profit in the income statement on the left, also called profit and loss. The balance sheet on the right shows we now have the same $100 in original capital plus $50 in earnings, which are equal to the $150 you have in cash as an asset.

Image of spreadsheet

Sell More Widgets

Buy another widget for $100 and sell it again for $150, and you have $200 in the bank. Do it again, you have $250 in the bank. Your income statement shows sales of $450, cost of sales of $300, and profit of $150. The illustration shows your income statement and balance sheet at this point.

image of spreadsheet

But What If You Sell to Businesses?

Now go back a step and make the situation more realistic. For example, most sales of products to businesses go on terms, with the money due in 30/60/90 days. So if you sold that widget on credit you don’t have $150 in the bank. You still have $50 in your bottom line, but now you have nothing in the bank. Instead, a customer owes you $150, which is what we call “Accounts Receivable.”

image of spreadsheet

Notice above that the bank balance is zero. We’re profitable, but there’s no money in our bank account. That’s a worry.

Buying on Terms

Knowing we can buy a widget for $100 and sell it for $150, we get our widget supplier to sell to us on the same terms we sell, net 30, instead of for cash. Now we have $100 that we owe to suppliers, which is called “Accounts Payable.” We also have $100 worth of widgets in inventory. This gives you the case in the following illustration in which we are now poised to sell another widget and make more profit.

image of spreadsheet

And Here’s the Key Problem

Take the situation above – profitable but no money – and add in an unhappy supplier. The widget vendor forecloses on its $100 debt.

And now, add in your own real-world experience in business. Add in the pressure of payroll, rent and all those other expenses that have to be paid. The business that gets stuck in this vice has some very unhappy owners.

Don’t get caught in this trap. Plan for working capital.

Conclusion: you need working capital.

In business, the example above is completely unrealistic. Where are the operating expenses, such as rent, salaries, telephones, or even advertising for those widgets? What supplier would give us a widget on credit when we have no history and no assets? What bank would loan us money in this situation? Banks do loan against inventory and receivables, but only to a certain percentage of total value. What was missing here, all along, was working capital.

Important: In strict accounting terms, working capital is equal to short-term assets minus short-term liabilities. In real terms, working capital is the glue that holds your cash flow together. Get it into the bank before you need it, or you won’t survive the unexpected.

About the Author:

Tim Berry
Tim Berry

Guest Blogger

Founder and Chairman of Palo Alto Software and bplans.com, on twitter as Timberry, blogging at timberry.bplans.com. His collected posts are at blog.timberry.com. Stanford MBA. Married 46 years, father of 5. Author of business plan software Business Plan Pro and www.liveplan.com and books including his latest, 'Lean Business Planning,' 2015, Motivational Press. Contents of that book are available for web browsing free at leanplan.com .