New Business Direction LLC
I’ll never forget my first tax season at a local CPA firm, one customer meeting in particular. We were sitting across the table from a nice young couple expecting their first child. They had started a small construction company that year and did quite well. The purpose of our meeting was to deliver the tax return, tell them the balance due for taxes, and answer any questions they might have about the Federal and state tax returns and future estimated tax payments.
When I shared with them that they owed just shy of $10,000 in income taxes, the young lady burst out in tears! They didn’t have the money. They had profits–but no cash. No one had ever explained the difference to them, and they were not expecting a balance due of that magnitude.
This meeting changed their lives and the course of my career. I never again wanted to sit across the table to deliver unexpected news to a bright-eyed entrepreneur and his expecting wife.
Therein began my career of teaching small business owners the difference between profits and cash, along with many other nuances of business ownership that no one ever tells you (including the fact that approximately 40% of your profits will go to pay income taxes). It’s a harsh reality, and knowledge is power. These outflows of cash can be planned when you have advanced notice. This type of planning is usually called tax planning, business planning, revenue planning, and/or profit planning. But knowing the difference between profit and cash is a good place to start — let’s dive in.
Here is the short and sweet on the difference between profits and cash. Profit is revenue minus expenses. Cash is money in minus money out. There is a fancy, seldom understood financial report called a Statement of Cash Flows that reconciles your profit to your cash, and is part of a comprehensive financial statement package which will also include your Balance Sheet and Profit and Loss Statements.
Most small business owners only look at the profit and loss, pay little (if any) attention to the balance sheet, and have never heard of the Statement of Cash Flows.
However, I would argue that the Statement of Cash Flows is the single most important financial report. It will tell you how much profit you made, where the money went, and what’s left of your profit.
There are certain things that you spend money on that are not tax deductible: some are not deductible at all, and some not immediately. They use cash, deplete your bank account, and do not reduce profits.
Let’s discuss a few common examples:
Equipment – you buy a new piece of equipment for your business. This might look like a walk-in cooler for a restaurant, a forklift for a warehouse, a work van for a construction company, a new stitcher for a manufacturing facility, or a company truck for the business owner. These items are Assets with a useful life extending beyond a one-year operating cycle and are reported on the balance sheet. They affect cash and do not affect profit until they are depreciated. When you make an investment in a piece of equipment like this, it is not immediately deductible. You’re out the cash and do not have an expense deduction–yet.
Loan Payments – Let’s say you buy that forklift and take a loan for it because the interest rate is better than what you’re making on your savings, or you don’t actually have the cash to pay for it outright. While the interest paid on the loan will be tax deductible, the loan payments themselves are not. The principal portion of the loan payment reduces the loan Liability account on the balance sheet. It affects cash, but never profits.
It is important to reconcile profits to cash, to find out where the money came from and where the money went. You never want to be caught short at the end of the year without enough cash to pay the taxes on the profits generated by your business. And hey, those federal income taxes you pay? Those are not tax deductible either.
While New Business Directions doesn’t prepare tax returns, our clients can benefit from the types of planning we mentioned above. Having a CPA in your corner throughout the year can make or break you at tax time–we can consult with you on the best time to make a capital expenditure decision, keep you informed about the speed at which cash is entering and leaving your business, and more. If you’d like to discuss cash vs. profit within your company, complete our intake form to get started.
Many small business owners focus on generating more revenue every year, and that’s a wonderful goal. But not all revenue is created equally since some items are more profitable than others. If you sell more than one product or service in your business, then you may benefit from looking at your revenue mix.
While it’s fun to watch revenues grow, your business profit is what really matters. If your expenses grow faster than your profits, then you have a lot of activity going on, but you don’t get to keep as much of what you make.
An insightful exercise to try is to take a look at your revenue mix. Then you can ask “what if?” to optimize your profits.
Your Revenue Mix
Let’s say you offer three different services: Services J, K, and L. Your revenue pie looks like this:
J: $700K or 70% of the total
K: $150K or 15% of the total
L: $150K or 15% of the total
Total: $1.0 million
In this example, Service J is clearly the service making you the most revenue in your business. But is it making you the most profits?
The profit you receive from each of these service lines is as follows:
J: $80K
K: $10K loss
L: $30K
Total: $100K
While Service J is generating the most profit volume for your business, it’s actually Service L that’s the most profitable. Earning $80K on $700K yields an 11.4% return on Service J, but earning $30K on $150K yields nearly double the return at 20%. Service L generates the most return. And if possible, Service K may need to be discontinued or turned around.
Optimizing Profits
Your strategy for a more optimum revenue mix might be to sell as much of Service L as possible while eliminating or fixing the problem around Service K.
It’s fun to experiment with different revenue mixes. And of course, there are many more variables besides profit, such as:
- What services/products do you prefer to work on/sell?
- Are you able to sell more of the most profitable service or are there marketing limitations?
- Is one service a loss leader for the others?
- Are you able to adjust the price on the lower margin services to increase your profits?
There are many more questions to ask and strategies to consider to make you more money, which is why we love being accountants.
A New Mix
We hope you’ll spend some time analyzing your revenue mix and having fun asking yourself “what if?” If we can help you expedite the process or add our perspective, please reach out anytime.
