The tools you need to understand your economic model and obsess over your cash flow—because invoices aren't the same as money in the bank.
Your Profit and Loss statement (P&L) is a great tool to help you understand your economic model and obsess over your cash flow effectively. And really—to have a full financial picture, you're going to want one in each hand: the Accrual Accounting P&L and the Cash Accounting P&L. That sounds jargony, so we'll explain why you need both.
Let's say you have a landscaping business, and you mow a neighbor's property. When you're done, you put an invoice in their mailbox that tells them they owe you $150. That invoice is a sign of performance: you've done $150 worth of work. That's great! But the homeowner may not pay you right away. They might wait thirty days. Or sixty. Or even ninety before they finally pay up.
See, that invoice is not the same as cash. That's why you need these two P&L statements:
Provides a clearer picture of the company's financial performance over a specific period of time by recognizing revenues and expenses when they are earned or incurred, regardless of when cash is actually exchanged. In other words, it tells you what money you have coming to you: "$150 due from Joe Neighbor, by September 1st" for the work that you did this week.
Provides a clearer picture for understanding cash flow, as it records revenue and expenses only when cash is actually received or paid. For example, it tells you what cash you have received in your bank account this month, regardless of when the work was actually done, e.g. last month.
We are not CPAs, but we do understand our numbers and our financial statements because we have studied them relentlessly for years. We recommend that you do the same and meet with your own CPA advisors to coach you on anything in your P&L statements that you do not understand as well as how to utilize these statements to both manage the business as well as optimize financial levers that can make a real impact.
In the early years, you will likely file taxes based on your Cash P&L, but once you achieve a certain size, you will need to transition your financial reporting to be Accrual-based. Again, assessing that, the benefits and requirements of each is beyond the scope of this book. The point that we want to convey is that to truly understand your business, you need to understand the numbers, the flow of the numbers, and how they are related. Mastering the P&L statement is a key part of that.
Okay, let's say you're looking at your Cash Accounting P&L, but you're still trying to do math in your head: It says we have $100,000 profit, but we had to take $40,000 out for taxes, and we did an owner's distribution as well… How much increase in cash did we realize over this period once we account for those items?
That's what the Cash Flow Report (e.g. Statement of Cash Flows) tells you. The Cash Flow Report shows the change in cash over a defined period of time.
The Cash Flow Report tells you the net change in cash over a defined period of time after all your expenses have been paid and distributions allocated.
This number does more for you than simply provide reassurance that you'll still have money in the bank. This number also tells you if you can grow. For instance, if you consistently have increases in Cash Flow, you are more confident in hiring your next employee.
We report on Cash Flow for the month ending. (Basically, once the books are closed for March, which would happen the first week of April, we look at what our free cash flow was for March. That's helpful data that gives us a sense of our trends.) We also project the next thirty, sixty, and ninety days. By making these projections, we protect ourselves from running out of cash or committing to a new obligation that could put us in a negative cash flow position.
P&L statements and the Free Cash Flow report: those are some of the tools that are going to help you measure and track your cash flow, enabling you to properly obsess over your cash numbers. The Balance Sheet is also very important; we recommend Greg Crabtree's writing to understand the following key insights from the Balance Sheet: 1) Return on Invested Capital, 2) Core Capital, 3) Trade Capital.
This is one of many measuring tools we share in The Good Business. Grab a copy to get the complete framework for bootstrapping a business to $10M and beyond.
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