Many people consider profit to be the best measure of a company’s success … but is it? Profitability is certainly important over the long run; but is it the only, or even the best, measure of a company’s success? Over the many years of helping small and mid-sized companies, we can confidently say that that positive cashflow (specifically cashflow from operations) is a better indicator of success than profit. Why does this matter … because profit and cashflow are two different things.
Cashflow is measured by the change in cash between the beginning and end of the fiscal year. Profit is the difference between revenue and expenses for the year. What makes them different … the accrual and matching principles of accounting. The accrual principle requires revenues and expenses be recorded when the transaction happens not when the payment is made. The matching principle requires that revenue be matched with the expenses incurred to generate the revenue. Depreciation is a non-cash expense that reduces the value of fixed assets (equipment and buildings but not land) to reflect how much economic value the company consumed.
Why does this matter … consider the following scenario:
A gizmo manufacturer had $5,000 in the bank on December 20th when they bought $1,000 of parts that they don’t have to pay for until January 4th of the following year. On December 23rd, the company sold $2,000 of gizmos with payment due on January 22nd. On December 31st (the company’s year end) the accountants calculated depreciation of $300.
Assuming those were all the transactions for the year, the income statement would show revenue of $2,000, expenses of $1,300 and a $700 profit. The balance sheet, however, would show that the company still has $5,000 in the bank.
If your company is facing financial challenges, please reach out to the NuFocus Capital team, We would be happy to meet with you to learn more about your business and discuss how we could help you overcome those challenges so you can get back on the growth track.