Why cash doesn’t equal profit
One of the biggest yet most common mysteries for freelancers and micro-businesses is why their accounts consistently show profit – yet they’re always struggling to find enough cash to meet their outgoings. Let’s take a look at why this happens so often.
Cashflow: positive or negative?
It all comes down to whether the business’s cashflow is positive or negative. In a nutshell, a cashflow-positive business brings money in before work is done or goods are provided; and a cashflow-negative business extends credit to its customers such that you have to finance the production of whatever they’ve ordered, and cover your own running costs, before you receive any payment from the client.
Whether your enterprise is cashflow-positive or negative likely has a lot to do with your industry. Renting out a property is a cashflow-positive business, because you would normally require a tenant to pay the rent a month in advance.
The creative industries, on the other hand, tend to operate a cashflow-negative business model, wherein the client is invoiced after the work has been delivered and is given up to a month to make the payment. It is these sorts of businesses that tend to struggle for cash even though their accounts show profit.
Meet Joe: a cash-strapped graphic designer
We will use a fictional freelance graphic designer – Joe – to explain why this lack of cash is such a common problem.
Joe signs a new client on 1st January, who agrees to pay him £1,000 to design a range of leaflets. Joe will need to hire a copywriter to write the text for the leaflets, which will cost £200. Therefore, Joe’s profit and loss account shows a gross profit for the project of £800 on 1st January.
The leaflets are ready a month later, and Joe raises an invoice on 1st February, requesting payment within 30 days. The client is slow to pay and Joe does not receive his £1,000 until 1st April. In the three months since Joe’s business registered its £800 profit, he has had to pay rent on the desk space he occupies. He’s also needed to pay a copywriter who wrote the text for the leaflets, and of course he has needed a certain amount of money on which to live. By the time the money comes in, Joe is already incurring expenses for his next project. Joe is running a cashflow-negative business, in which he is always struggling to find enough money for his outgoings.
How could Joe achieve positive cashflow?
The good news is that someone like Joe could take some simple steps towards a cashflow-positive business model that can get him out of the cycle of living ‘hand to mouth’.
When Joe signs his next client he can:
• Require the client to pay half of the fee as a deposit at the outset
• Give the client a 14 day, rather than 30 day, credit window to pay any remaining balance
• Chase the payment as soon as it is late, rather than simply waiting for the client to pay
• Negotiate better credit terms with his own suppliers, e.g. the copywriter, to ensure money comes into the business before it goes out
• Monitor his outgoings and incomings in real time by using online accounting software
By tweaking his business model in this way, Joe’s profit is unaffected – but he can minimise the possibility of running out of cash.
