Steve called me up the other day to ask, “Where’s all my money?” I did a double take, thinking he wanted me to pay HIM.

“What do you mean?” I asked.

Turns out, Steve is invoice rich, but cash poor. Meaning, he has plenty of business, invoices going out and payments coming in, but he also has a lot of cash going out. He needed to understand the difference between cash flow and profitability.

The definitions are pretty clear, but sometimes the application is a little more complicated. Cash is the amount of money you have in your wallet, in your bank, or under the mattress. Simple as that. Cash flow is the actual movement of that money in or out of the business. Profit is the (theoretical) amount of money you keep after you pay your expenses, it is closely related to cash and cash flow, but it is NOT cash.

Steve’s design agency is doing alright. They generate $1.2 million in revenue and earn a 5% net profit on that volume. Steve’s customers pay 30 days after he invoices them. And here’s exactly where the gap occurs. At month 1, Steve incurred $95,000 in expense that he had to pay out in cash (utilities, rent, employees) but didn’t receive a dime in cash on the $100,000 of revenue that he had “earned.”

What he really needs to understand is how he can convert that revenue into cash fast enough to sustain his business. This may mean he needs to increase his prices. At his current profit level of 5% profit, it will take him 2.5 years to climb out of this initial cash hole of $95,000. If he increases his rates to gain a 10% profit, he will be able to become cash flow positive in 16 months. Still not fantastic, but it’s a significant time saving.

Steve needs to make a decision as to whether to increase his rates for clients so that he can break even more quickly. Obviously, this is more than just a decision based on money. He also needs to understand his client base to see if it can sustain a rate increase.

If Steve’s story sounds familiar, then your company has either been in his shoes or you know someone just like him. Many mid-sized businesses are profitable, but have cash flow problems that can take them down. Having an understanding of your current cash flow picture is essential for making strategic decisions around your business.

In my next few blog entry, I’ll discuss how to systemize accounts receivable in order to get paid faster.