This is a guest post from Fiona McKenzie at Blue Note Solutions Ltd:
When starting a business most people recognise that there will be an initial period when all the cash is going out and none coming in. What is not so well understood is that, even once trading profitably, cash in the bank will not necessarily follow. In fact, in my experience even established businesses often require an overdraft at certain times in their business cycle.
Profit does not immediately result in cash because of timing differences. In most businesses you will incur your costs before receiving the revenue.
For simplicity we’ll assume the business is a shop. Stock of £1000 is purchased in the first month so the overdraft is £1000.
Stock is sold at a profit on cost of 25%. At the end of the second month all stocks are sold. The shop has received £1250 sales revenue, cost was £1000 and month 2 profit is £250.
But to continue trading shop needs to replace the stock, another £1000. The cash position at the end of month 2 is:
Month 1 overdraft (£1000)
Month 2 sales receipts £1250
Month 2 replacement stock (£1000)
Bank overdraft month 2 (£750)
It will take some months of profitable trading to repay the overdraft. This is one reason that, when businesses apply for loans, banks will normally require cash flow as well as anticipated trading forecasts.
Perhaps counter-intuitively the more quickly your business increases, the higher the overdraft required. If shop knew it would be able to treble the month 3 sales, in month 2 stock purchases would need to be £3000.The overdraft then required would be £2750.
Over 3 months a shop with steady sales would have a profit of £500 and overdraft of £500. A shop with expanding sales would end 3 months with profits of £1000 but an overdraft of £2000.
Whatever your financing method you will need to carefully monitor your cash requirements. If you run out of cash however profitably you are trading you can run out of business.
To read a more detailed article on this topic, with illustrations, please visit http://www.bluenotesolutions.co.uk/cash-profit-and-your-growing-business/
About the author: Fiona McKenzie is the Director of Blue Note Solutions Ltd based in Oxford. Fiona helps SMEs gain clarity and control of their financial performance. She offers a complimentary Profit Improvement Review to SMEs based around Oxford and the Thames Valley.