Reference no: EM133304579
Cash Does Not Equal Profits
Profit (or net income) is the difference between a company's total revenue and its total expenses. It measures how efficiently the business is running. As important as earning a profit is, no business owner can pay creditors, employees, and lenders in profits; those payments require cash.
Profits are tied up in many forms, such as inventory, computers, or machinery. Cash is the money that flows through a business in a continuous cycle without being tied up in any other asset. Cash flow is the volume of cash that comes into and goes out of the business during an accounting period.
Decreases in cash occur when a business purchases, on credit or for cash, goods for inventory or materials for use in production. When cash is taken in or when accounts receivable are collected, the firm's cash balance increases. Purchases for inventory and production lead sales; that is, these bills typically must be paid before sales are generated. But, the collection of accounts receivable lags behind sales. However, customers who purchase goods on credit may not pay until a month or later.
A company can operate in the short run at a negative profit, but if its cash flow is negative, the business is in trouble. It can no longer pay suppliers, meet payroll, pay its taxes or any other bills. In short, the business is headed for extinction.
DISCUSSION QUESTION
Why must small business owners concentrate on effective cash flow management?