Do You Know the Difference Between Cash Flow and Profit?


“That is exactly why we cannot loan you the money you need,” I said in response to a potential client explaining to me that he has over $20,000 a month going through his account.

Cash is king. If you have it, you stay in business. If you don’t… you don’t. A lot of money going through your account does not matter. In fact, that is not a good thing unless the money into the account is more than the money out. In this case, this particular client was doing very well financially on paper. He had a high net worth and several assets. The problem is, he set up the loans on his rentals to pay them off early and was spending all of his rent, and sometimes more than his rent, to make the payments.

These rentals were profitable because income was more than the expenses, but he had no cash flow. The principal portion of your payment each month is a reduction of debt, so it is not an expense. In the long run this will prove beneficial, but it is risky. In this case, he was using shorter term amortizations to reduce his loan size quickly. All of his loans were set up as 15 year loans. Although, with the exception of a default, this is a sure fire way to speed up the loan payoff, I believe there are better ways to do it.

I made a similar mistake when I was really young. Whenever I got some cash in the bank I would want to invest it right away. After all, money in the bank is not working for me. I could earn much higher returns in other investments. I was buying houses at a rapid pace, and quickly became a millionaire. I was extremely proud that I hit that status long before my 30th birthday. The lesson I learned the hard way is that your net worth really doesn’t mean much. Net worth is simply your assets minus your liabilities.

All my assets were in real estate. It was easy to buy discounted properties, so I increased my net worth each time I purchased a home. I am sure you have heard the term, “you make money when you buy.” That could not be truer. Although you make money when you buy, you can’t spend it until you sell. My model was almost exclusively buy and hold, so I never really generated the cash reserves I needed to withstand a problem. And a problem is exactly what I got. I was a millionaire and could not pay my bills.

I am a big leverage guy. I believe strongly that you need leverage to reach your potential. You will make more money and grow faster with leverage. Although I think you need to leverage people as much as money, I am going to focus on money for this point. If you have a lot of leverage in the way of loans, you need to make money to pay it off. Companies, and frankly our Government, end up spending all of its revenue to pay off debt; and although they are profitable, they are broke.

Once I shifted my focus to cash flow I was able to rebuild a much stronger financial picture. I rebuilt much more slowly and smarter. I still love and use leverage, but I am smart about it and stay diversified. I have access to cash if I run into a problem, and I use my assets to steadily pay off debt AND produce cash each and every month.

Cash Flow Statements and Why We Need Them

36A cash flow statement is the motor oil for any business finance engine. It measures the amounts of money that come into a company and out of it over a given time period. This way a company is able to keep track of how much cash it has on hand to pay expenses and buy assets.

Some people might confuse a cash flow statement with an income statement. An income statement only measures whether or not the company made a profit, whereas a cash flow statement can tell you whether or not the company generated c ash during the time period. These concepts may seem a bit confusing. Just because a company has generated cash does mean that it has generated profit and vice versa. Cash flow statements work particularly with cash where as income statement s may also deal with assets.

Cash flow statements use information from both income statements and balance sheets. Using this information, the cash flow statement will reveal the net increase or decrease in cash for the period. Most cash flow statements are divided into three separate activities: operating activities, investing activities, and financing activities.

Operating Activities

Operating activities shows cash flow from net income to net losses to cash used in and for operation procedures. Sometimes, non- cash items are adjusted for any cash that was used or provided by utilizing other operating assets and liabilities.

Investing Activities

Investing activities is usually the second part of a cash flow statement. This includes the purchases or sales of long-term assets, such as property, equipment, and even stocks. These actions are still represented as ” cash in” or ” cash out” depending on what is purchased.

Financing Activities

This is the third part of the cash flow statement. And, as the name might suggest, the financing activities section tracks financing activities. For large companies this includes money raised by issuing stock in the company, or borrowing many from banks. Paying back these loans are also considered under this section of the cash flow statement.

Components of Cash Flows

41A typical investment will have three components of cash flows:

1. Initial investment

2. Annual net cash flows

3. Terminal cash flows

1. Initial investment

Initial investment is the net cash outlay in the period in which an asset is purchased. A major element of the initial investment is gross outlay or original value of the asset, which comprises of its cost (including accessories and spare parts) and freight and installation charges. Original value is included in the existing block of assets for computing annual depreciation. Similar types of assets are included in one block of assets. Original value minus depreciation is the assets book value. When an asset is purchased for expanding revenues, it may require a lump sum investment in net working capital also.

Thus initial investment will be equal to: gross investment plus increase in the net working capital. Further, in case of replacement decisions, the existing asset will have to be sold if the new asset acquired. The sale of the existing asset provides cash inflow. The cash proceeds from the sale of the existing assets should be subtracted to arrive at the initial investment. We shall use the term Co to represent initial investment. In practice, a large investment project may comprise of a number of cost components and involve a huge initial net cash outlay.

2. Annual net cash flows

An investment is expected to generate annual flows from operations after the initial cash outlay has been made. Cash flows should always be estimated on an after tax basis. Some people advocate computing of cash flows before tax basis and discounting them at the before-tax discount rate to find net present value. Unfortunately, this will not work in practice since there does not exist an easy and meaningful way for adjusting the discount rate on a before-tax basis. We shall refer to the after-tax cash flows as net cash flows and use the terms C1, C2, C3…… respectively for in period 1, 2, 3………n. Net cash flow is simply the difference between cash receipts and cash payments including taxes. Net cash flow will mostly consists of annual cash flows occurring from the operation of an investment, but it is also be affected by changes in net working capital and capital expenditures during the life of the investment. To illustrate, we first take the simple case where cash flows occur only from operations. Let us assume that all revenues (sales) are received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation since it is a not-cash expense). Thus, the definition of net flow will be:

Net cash flow = Revenue – Expense – Taxes

Notice that in equation taxes are deducted for calculating the after-tax flows. Taxes are computed on the accounting profit, which treats depreciation as a deductible expense.

3. Terminal cash flows

The last or terminal year of an investment may have additional flows.

• Salvage value

Salvage value is the most common example of terminal flows. Salvage value may be defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will be treated as cash inflow in the terminal (last) year. As per the existing tax laws, no immediate tax liability (or tax savings) will arise on the sale of an asset because the value of the asset sold is adjusted in the depreciation base assets. In the case of a replacement decisions, in addition to the salvage value of the new investment at the end of its life, two other salvage values have to be considered:

1. The salvage value of the existing asset now (at the time of replacement decision)

2. The salvage value of the existing asset at the end of its life, if it were not replaced.

If the existing asset is replaced, its salvage value not will increase the current cash inflow, or will decrease the initial cash outlay of the net assets. However, the firm will have to forgo its end-of-life salvage value. This means reduced cash inflow in the last year of the new investment. The effects of the salvage values of existing and new assets may be summarized as flows:

• Salvage value of the new asset. It will increase cash inflow in the terminal (last) period of the new investment.

• Salvage value of the existing asset now. It will reduce the initial cash outlay of the new asset.

• Salvage value of the existing asset at the end of its nominal life. It will reduce the cash flow of the new investment of in the period in which the existing asset is sold.

Sometimes removal costs may have to be incurred to replace an existing asset. Salvage value should be computed after adjusting these costs.

Investing In Residential Real Estate For Positive Cash Flow

40To any savvy investor, real estate was the tried and true model for consistent return on investment. At least that was prior to the 2008 crash and the chaos that followed. Now terms like subprime mortgages, NINJA loans, and predatory lending have left a nasty taste in the mouths of many Americans shaking their trust and leaving wide open a golden opportunity for people willing to go against the grain. It is true that buying real estate these days takes some real effort. Financing residential real estate takes more than the traditional route of going to your local bank and taking out a traditional loan. Especially if the investor hopes to turn newly acquired real estate into positive cash flow, after all while the housing market has certainly improved there is no shortage of “for sale” signs in the suburbs.

During the early 2000’s the trend in residential real estate was monolithic homes that took up two or three lots gobbled up by developers. The many “McMansions” still stick out in otherwise inconspicuous neighbors, remnants of the unique hubris of owning a large home even if it meant you couldn’t afford to live there. Of course developers made money this way; they also lost their shirts this way in 2007 and 2008 when they could no long sell these homes and the loans defaulted. So like all other times in history were demand falls, supply tappers off, but that demand was simply for huge houses not for housing. Every American still needs a home, and now is willing to settle for lease since they have already lived through the recession. Really average young Americans have to rent, after all banks are simply not willing to give out mortgages to millennials who, unlike their parents, are more and more often being confronted with staggering student debt and a shakier job market.

So then what is left? The answer is simple; invest small, and invest in rental properties. If you want a real positive return on your investment the soundest course to take it to acquire foreclosing and short sale properties from neighborhood banks. Sometimes these properties have a tendency of being beaten up and will require some work to improve them enough to rent, but when compared to building new the initial investment is minuscule. This tactic can allow you to find a property for much less than it’s estimated value and so can turn the CAP rate to your advantage. However, to truly turn a property around and have it cash flow positively requires a very important consideration, more important than even how inexpensive the property was; your market. If you want your newly acquired (formally foreclosed) piece of residential real estate to start producing revenue right away than it becomes important to understand the demographic you are trying to attract.

If you want to take advantage of the new real estate trend, and at the same time maximize your profits, then you should aim small. Americans no longer want the 4,000 square foot brick homes with 5 bedrooms and 3 full baths; they want to live where the utilities are small and the taxes aren’t huge. This trend isn’t just for home owners/ renters; it is all the rage in apartments too. The advent of the “micro unit” (really just a 280 square foot studio) is taking over San Francisco, and New York where young professional would rather be out in the city than staying inside. The mind set of many suburban markets is minimalist too, just the basics, and that couldn’t be better if you are investing in single family homes. After all there are still plenty of big homes on the market, but smaller and older homes are sold much sooner.

So if the hope is to maximize your investment on residential real estate then the strategy is simple: look for foreclosing/ foreclosed properties, invest in distressed properties that can be fixed up quickly, and aim small. A 1940’s two bedroom home can offer more to an investor, even if it doesn’t feel like such a huge return, but the goal is consistency. It better to make consistent positive cash flow than to take a big risk and buy big, and wind up sitting on a property that could have already been rented out if it were smaller. In today’s market the old adage of “go big or go home” could literally not be more wrong.

Cash-Flow Woes and Antidotes

39Lucky you! Your sales pitch is working and clients are stacked up like planes landing at O’Hare. Receivables are numerous and the balance sheet rocks. So how can it be that you almost didn’t make payroll (again)? How can you come up short on cash, with all the business you’re creating?

Like so many business owners, especially those who are new or who suddenly acquire a competitive advantage that creates a tidal wave of business, you did not recognize the signs of an approaching cash-flow crash, independent of how much money would eventually flow into your coffers.

You placed your primary focus on creating business (which is vital), but neglected to monitor the ebb and flow of revenues and expenses (which is vital). Every business owner must keep an eye on the money and take corrective actions as needed if we want to build a thriving business because quite perversely, as sales go up, cash-flow might go down.

Here’s how cash-flow crashes happen. As business expands, staying on top of accounts receivable becomes more time-consuming. Those in service businesses (like website design or public relations) may find that clients, oftentimes those whose names we crave for our client list, may unilaterally decide to pay receivables in 60 days, instead of 30 days. Meanwhile, you have payroll and other operating expenses that are due ASAP.

Improper pricing is another cause of cash-flow crashes. You may sell a ton of T-shirts but if the profit margin is too thin, excellent sales volume may not overcome an inadequate mark-up. Revenues generated may not cover expenses. The remedy is to either acquire the product less expensively, or raise the price.

A growing business brings up still more issues that keep its owner awake at night: capital expenditures. You must decide whether or not and when to upgrade office equipment, open a new office or move to larger quarters, or hire more workers to keep up with the growing number of customers.

Fail to invest in capacity and you leave money on the table, along with dissatisfied customers who can kill you on social media. Get fooled by the romantic delusion of further growth, invest in demand that never materializes and you are stuck with potentially crippling debt that can bankrupt the business.

It’s quite the dilemma and only the best fortune-teller can give the right answer. John Terry, of Churchill Terry business advisers in Dallas, TX, recommends that business owners focus on one question only when evaluating the possibility of making large capital investments: will it bring money in the door? If not, find a less expensive alternative, or learn to make do without it. Successful business owners learn to preserve and protect liquidity. Here are other actions to take:

  • Hire a savvy bookkeeper or accountant to function as the business controller (full or part-time)
  • Each week, collect the data on key financial indicators: accounts payable, accounts receivable, available cash and the quick ratio (cash + receivables / current liabilities + accounts payable) to monitor that all-important liquidity
  • Each month, collect the data on these indicators: accounts receivable turnover ratio (how long does it take to get paid?), the operating cash-flow ratio (cash-flow from operations / current liabilities) and the pre-tax net profit margin

It is imperative that you are able to pay obligations when they are due and for that you need cash in hand. Analyze the above indicators weekly and monthly and learn what is really happening behind the scenes of your business. Track the trends of available over time.

Seasonal variations may become evident. You may need to step up receivables collections, or approach certain clients about speeding up payments. You may start to request more money up-front before taking on certain projects, so money will come in faster. You may trim expenses and raise prices. The decision of whether to invest in capital upgrades will become clearer.

There are software programs to track important data and help business owners resolve problems and set priorities. Accounts receivable, cash, inventory and liquidity can be monitored, along with confirmation on whether the business is on target to meet budget and revenue goals. For those businesses that get lots of repeat business, it is also possible to track the profitability margins of key clients.