This is the first article in a three-part series on how to prevent your operation from joining those who are driving the increasing mortality of U.S. small businesses.
One of the pillars of the American Dream is the ability of any citizen to start a business from scratch, build it, own it, and pass it along to their heirs. Research indicates that there are more than 25 million of these dreams come true in the U.S. Approximately eight million have employees, the balance are independent contractors, professionals, etc., and together they create half of the U.S. economy. All of that is the good news.
The bad news is that the rate of small business mortality – when the dream turns into a nightmare – which was once 50% in five years, has now increased by 20% in the past 20 years (U.S. Small Business Administration). The reason for this unfortunate trend is associated with Blasingame’s 1st Law of Small Business: It’s easy to start a small business, but it’s not easy to grow one successfully.
The smoking gun that kills most small businesses is the founder’s ignorance of or disregard for the financial fundamentals of business. And most of this business carnage could be avoided if every Founder understood what I call the Five Financial Mysteries. In this installment, I’ll reveal the first Mystery with the others to follow soon.
You could be forgiven for calling me out on referring to tried and true operating fundamentals as mysteries. But based on the disturbing business mortality stats, that’s my story and I’m sticking to it.
You’ll notice that all of my Financial Mysteries are influenced by the relationship between four abiding, immutable, non-negotiable, overriding, imperative (you get the picture) operating elements: cash flow, accounting, the relationship between the two, and the impact of time on both. On that last element, notice how often the word or the concept of time – days, annual, depreciation, amortization, incremental, period, etc. – is used. Now, prepare to have the first Mystery revealed.
Financial Mystery 1
Cash flow and accounting are not the same things.
In its simplest terms, accounting is doing the math on the relationship between what comes in (revenue) and what goes out (disbursements). Inside that math you “account” for the business’s activity by groups, such as sales, inventory, expenses, etc. The manifestation of all this accounting is a set of financial statements which will help you manage your business and provide proper reporting to others, like your banker and, of course, the tax man. Remember, profit is accounting, not cash.
Cash seems simple enough – you either have it or you don’t. But the impact of time on the marketplace makes understanding cash flow tricky, and frankly, unintuitive. Remember: cash is not profit. Once more with feeling – Cash is not profit!
If there were no taxes, depreciation, or amortization, if everyone paid cash “on the barrelhead” (no “net 30” accounts), if we didn’t need inventory, and a few other “ifs”, then managing your business’s finances would be simpler. Marketplace timing would be eliminated, accounting would not be necessary, and your cash flow would more closely reflect the financial health of your business. But such a universe is only occupied by business owners whose dream will eventually become … well, you know. Even a fourth grader’s lemonade stand has inventory, which is the state of some of little Susie’s cash during the time it takes to convert lemons, sugar, water, and cups back into cash again.
The timing relationship between accounts receivable and accounts payable (more on this later), the repayment of debt over time, the conversion of cash to inventory, and the timing of the tax treatment of certain assets are fundamental reasons why cash flow and accounting are not the same things. And why both have to be simultaneously managed well and differently.
Two last little nuggets: Sales revenue isn’t profit, and you can’t spend a credit sale until you get the cash.
Write this on a rock … Avoid joining that business mortality statistic by becoming an expert on the relationship and the difference between cash and accounting, and the impact of time on both.
Next time, two more Mysteries are revealed: Cash is a business’s oxygen, profit is its nourishment.