A financial understanding of your business is critical in ensuring that you remain profitable. Why then do so many people falter when asked what is your gross profit? Or what should you be allowing for costs against a gross profit? What is cash flow forecasting?
In this short article, I will explain some of these simpler terms. I have called this finance for the non-financial mine. It should in no way replace the need for a qualified accountant, as I explain them from an entrepreneurs perspective.
Cash is King
The first rule to remember is that cash is king. Cash is money that you can free up immediately in your business and often is held in a bank or savings account. If you run out of the cash needed to run your business and cannot satisfy the people that you owe money to, you are insolvent. In this case, there is a strong risk that your business will close. You can therefore understand why Cash is King
How does cash come in and leave the business?
Cash comes in usually in the terms of income (sales) and Cash leaves the business as an Expense. The following equation is often referred to
Income – Expense = Profit (Loss)
This calculation can give you an immediate picture as to the profit or loss that is being generated by the business.
- If Income is greater than the expense, then you are in a profit situation.
- If Income is less than the expense, then you are in a loss situation.
Whichever situation you are in, the figures tend to roll from month to month. From this, you can predict what the future cash flow forecast is. The cashflow forecast is how much money you are predicting to be in the business when you have taken into account all the Income less Expenses of a period of time.
Lets work this through with an example.
You have just sold Widget X to a new client for $100. It costs you $34 to make the Widget and $6 to ship the product to the client.
Your profit is therefore $100 – ($34+$6) = $60. This is termed your GROSS profit. In this example, the gross profit is 60% of sales.
The GROSS profit is the cash that you make when you take into account any costs incurred when you make and sell this product.
It is likely that you are paying yourself a salary, perhaps rent a building and have a loan to repay when you purchased the equipment. These are all fixed costs and ultimately still need to be deducted from the Cash or profit that you have generated.
When we take a proportion of this at the product level (say $35 per widget) – your net profit is $60 less $35 which is $25 or 25%.
It is really important to keep your net profit positive else you will be losing money and will eat into any cash that you have in your bank.