1. What you will learn
This lesson explains why profitable businesses run out of money, with special attention to the growth trap: the faster you grow, the more cash the business consumes. You will see how accounting choices create profit that is not yet cash, build the bridge from profit to cash for a growing business and learn the early warning signs.
2. The idea explained
Profit is an opinion in the sense that it depends on choices. When do you record a sale, at dispatch, at invoice or at payment? How do you value stock that has not sold? How quickly do you spread the cost of a machine? Reasonable accountants can disagree at the margin, and the rules require you to match costs to the period of the sales they helped earn. Cash is a fact. The bank statement shows what came in and went out. Both are useful, but only cash pays wages, suppliers and instalments.
The difference between them has recurring sources. Sales recorded on invoice but not yet collected raise profit but not cash. Purchases of stock reduce cash immediately, but reduce profit only when the stock is sold. Equipment bought for cash reduces cash at once, while profit bears only the yearly depreciation. Repaying the principal of a loan uses cash but is not an expense. Tax paid in instalments follows a schedule of its own. Advances from customers raise cash before revenue is recorded, and can make a business look healthier than it is.
Growth magnifies all of these. A growing business sells more, so receivables rise. It needs more stock to serve more customers. It may buy equipment or hire staff before the extra sales arrive. The extra profit from growth comes later than the extra cash needs. If working capital is thirty per cent of sales, every rupee of new sales ties up thirty paise before it turns into cash. A business that grows fifty per cent can therefore show record profit and be unable to pay salaries.
Warning signs include rising receivable days, rising inventory days, growing reliance on the overdraft, delayed payments to suppliers, tax payments missed or made from borrowed money, and owner injections that become routine. Any one can be temporary; several together mean the business is financing its growth badly.
The remedy is not to avoid growth but to plan its cash: forecast weekly, compute working capital needs before accepting a large order, negotiate advances or milestone payments, and line up funding before you need it. Rules on lending and tax vary, so confirm them with your lender and accountant.
Apply it
3. How to apply it in your own business
Compute the profit-to-cash bridge for the last quarter. Start with profit before tax. Add back depreciation. Subtract the increase in receivables and in stock. Add the increase in payables. Subtract loan principal repaid and equipment bought. Subtract tax paid, if not already in profit. Add any customer advances received. Compare with the actual change in the bank balance and explain the difference.
Compute working capital as a percentage of sales: inventory plus receivables minus payables, divided by annual sales. Use it to estimate the cash that extra sales will absorb. Multiply the expected increase in sales by that percentage.
Before accepting a large order or launching a new product, prepare a mini-forecast: what do I pay out and when, and when will the customer pay? Find the lowest cash point. If it goes negative, decide the funding: advance payment, milestone billing, supplier terms or a bank facility discussed in advance.
Watch the warning signs each month: receivable days, inventory days, overdraft use, supplier delays. Note the direction over three months. Discuss with your accountant if several move the wrong way.
Finally, keep profit and cash in the same conversation. When someone reports a good month, ask both questions: what was the profit, and what was the change in the bank balance? Ask the accountant for the bridge each quarter.
Worked example
4. Worked example
Vinay runs an interior fit-out business. In year one, sales were 40 lakh rupees, net profit 4 lakh, and working capital, receivables plus stock minus payables, was 12 lakh, or 30 per cent of sales. In year two, sales grow 50 per cent to 60 lakh, profit to 6 lakh, and working capital at the same 30 per cent rises to 18 lakh, an increase of 6 lakh.
He also repays 2 lakh of loan principal and buys 1 lakh of equipment. Depreciation of 0.5 lakh is included in expenses.
Bridge for year two: profit 6.0, plus depreciation 0.5, minus increase in working capital 6.0, minus loan principal 2.0, minus equipment 1.0. That is 6.0 plus 0.5 minus 6.0 minus 2.0 minus 1.0, which is minus 2.5 lakh. A record profit of 6 lakh produced a cash outflow of 2.5 lakh.
Warning signs: receivable days rose from 48 to 62 because two large clients pay after handover; inventory days rose from 30 to 38; supplier payments were delayed by a week; and his overdraft rose from 1 to 4 lakh. Several signs together.
His response. First, he changes billing: 30 per cent advance, three milestones and a final payment after handover, aiming to cut receivable days to 45. On a business of 60 lakh, cutting 17 days of receivables releases 60 times 17 divided by 365, which is about 2.8 lakh. Second, he forecasts every large order for its lowest cash point before accepting it. Third, he asks his bank for a working capital limit while the business looks healthy, accepting that the decision is the bank's. He reports both numbers each month: profit and change in cash. He also notes that his 30 per cent working capital ratio is an estimate that varies by project.
5. Common mistakes and how to fix them
The first mistake is celebrating profit without checking cash. Ask both questions each month.
The second mistake is accepting large orders without a cash forecast. Find the lowest cash point first.
The third mistake is seeking funding when already short. Talk to lenders while the numbers look healthy.
The fourth mistake is using customer advances as if they were earned. Treat them as obligations to deliver.
Key takeaways
6. Board summary
Profit depends on accounting choices; cash is a fact. Receivables, stock, equipment, loan principal and tax explain the gap. Growth absorbs cash before it produces it. Multiply extra sales by working capital percentage to estimate cash needs. Watch receivable days, inventory days, overdraft and supplier delays.
Check your understanding
7. Practice and self-check
- Profit 5, depreciation 0.4, receivables up 2, stock up 1, payables up 0.5. Approximate cash? Answer: 5 plus 0.4 minus 2 minus 1 plus 0.5, which is 2.9 lakh.
- Working capital is 25 per cent of sales; sales grow by 8 lakh. Extra cash absorbed? Answer: 2 lakh.
- Vinay's cash change in year two? Answer: minus 2.5 lakh.
- Why can a profitable business run out of cash? Answer: receivables, stock, equipment and loan repayments use cash before profit turns into it.
- Is loan principal an expense? Answer: no, but it uses cash.
- Cutting receivable days by 10 on sales of 73 lakh releases? Answer: 73 times 10 divided by 365, which is 2 lakh.
- Name two warning signs. Answer: rising receivable days and reliance on the overdraft are examples.
- Why ask a lender early? Answer: facilities are easier to arrange while the numbers look healthy, though the decision is the lender's.
- How should customer advances be treated? Answer: as obligations to deliver, not as earned revenue.
- What two questions should you ask about a good month? Answer: what was the profit and what was the change in cash.