Understand why cash is king

The most common reason that businesses fail is not through lack of profit but through lack of cash. Many failed businesses are highly profitable but run out of cash.

Profitability versus liquidity: Whereas profitability is the return generated by a business, liquidity is the ability to pay expenses and debts as and when they fall due. Liquidity is essential for the financial stability of a business. A failure to manage liquidity may lead to a, being unable to pay its suppliers, employees and debt holders, which may ultimately lead to bankruptcy.

Cash is like Oxygen:  A useful analogy is that profit is like food, whereas cash is like oxygen. The “survival rule of threes” states that people can survive three weeks without food, three days without water but only three minutes without oxygen. Similarly, a business can survive without profit in the short term but cannot survive without cash. If employees and suppliers are not paid, the business will not survive for long.

When the cash runs dry:  Although this sounds simple, many businesses don’t place enough attention on their liquidity.  Firstly, businesses are not realistic when predicting/estimating their cash income and cash expenses. Generally, they overestimate income and underestimate expenses. Secondly, not enough businesses regularly forecast cash flow and foresee problems before they arise. When they run out of cash it’s often too late.

Ideal Goals: Naturally, both a healthy cash flow and high profits is an ideal goal, but in practice it is not that easy. The short-term goal of a business should be to manage cashflow, and the medium to long term goal to manage profitability.

Deciding a suitable cash balance: Business should discover their optimum balance of cash flow. There is a balance between holding enough cash to meet all short term demands and utilising cash in more profitable investments. There is thus a trade-off between holding sufficient liquid assets and investing in more profitable assets.

Successful businesses manage cash flow in the short term and manage profit in the medium to long term.