Net Cash Flow, Better Than Net Profit?

Traditionally when you think of business performance you generally think of Net Profit, after all, any business should ordinarily have profit as it’s primary aim.

When it comes to raising finance it has to be asked whether Net Profit is the right measure to use for affordability, or whether it should actually be Net Cash Flow.

So What Is The Difference?

You could make profit and have no cash, or make a loss and generate cash. At the end of the day it will always be cash that pays the bills, profit is simply what the taxman wants to see.

It always surprises us that more lenders do not look at Net Cash Flow before they look at Net Profit.

Let’s try a simple example –

  • Sales                     £500,000
  • Net Profit               £50,000
  • Net Cash Flow      (£10,000) (in other words a loss of cash)

How?

Let’s assume the Balance Sheet shows the following –

  • Year                     Last Year               This Year
  • Debtors                £50,000                 £85,000
  • Creditors              £75,000                 £50,000

So, very simply, the business made £50,000 in profit but is owed an extra £35,000 and has repaid £25,000 of creditors. The effect being the business has £60,000 less cash this year, when profit is added back in there is a shortfall of £10,000.

This could be that your creditors have shortened payment terms, meaning you have to pay them sooner, whilst the people who owe you money are taking longer to pay up.

So, if you were to borrow money and repayments were £10,000 per year, then where would the cash come from to meet these repayments? After all, your profit says your repayments are affordable.

Let’s Look At Things The Other Way Round

For this we will assume the accounts say the following –

  • Sales                             £500,000
  • Net Loss                        (£10,000)
  • Year                              Last Year                 This Year
  • Depreciation                 £10,000                    £10,000
  • Debtors                        £40,000                    £30,000
  • Creditors                      £25,000                    £30,000

In this example the business made a loss of £10,000 but there were the following items to add back in –

  • Depreciation of £10,000 per year
  • Debtors changed £10,000 in your favour (you were paid more quickly or collected in debts)
  • Creditors extended by £5,000 (you may have better credit terms)

So in this case the business lost £10,000 but actually generated £15,000 in cash (£10,000 loss with £25,000 cash added back in).

The argument here is what is better? Cash will make the finance repayments, so in reality the loss making business is actually a better risk in terms of affordability.

So What?

Our argument is that Net Profit is not necessarily the best measure. We say Cash Is King, so let’s stick to our principles.

We always encourage our clients to look at both profits and cash.

What Next?

If you have any comments, or if we have simply confused you, then please add your comments below, contact us via the website, or call us on 01293 541333 and we will gladly talk you though it.

 

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