Why Profitable Studios Can Experience Tight Cash Flows

 

A new client came to us a little over a year ago.  We’ll call them Awesome Co.; which they are.  A young and ambitious business with a few large exciting contracts and several smaller but equally interesting projects.  A quick glance at their Income Statement (see our post on Financial Lingo) would reveal what appears to be a healthy company: strong revenue for a company their size, an efficient balance of employees and subcontractors in their people structure, and a healthy net profit margin.  What this picture doesn’t reveal however is that they had found themselves on the brink of bankruptcy twice in the past year.   How is that possible?

 

This real example highlights two interesting nuggets:

1. Positive Net Income Does Not Mean Strong Cash Flow

2. A Company’s Annual Financial Statements Tells You Very Little about Its Operating Performance

Let’s expand on these two ideas but before we do, a quick look at what Net Income and Cash Flow are:

 

Net Income

Net Income (aka: Net Profit or “bottom line”) is the money left over from revenue after all your expenses are paid for…on paper.  By “on paper”, I mean that Net Income at the end of the day is a non-cash accounting number called “accrual”.  The Accrual method is based on accounting matching principles required to calculate the final net income number which often has no relation to the cash in your bank account. It unfortunately takes some serious accounting knowledge to fully understand accrual accounting.

 

Cash Flow  

Cash Flow is aptly named as it is the stream of cash that flows in and out of a business bank account.  Inflows include deposits for work yet to be completed, clients’ paying their invoices, and collections on outstanding invoices from clients that need a little push.   Outflows include regular expenses like rent and wages as well as less frequent items such as taxes, loan payments or office furniture purchases.

 

Let’s return to the two lessons from our example above with Awesome Co.

 

1. Positive Net Income Does Not Mean Strong Cash Flow.

How is this possible?  In simple terms; the main culprit is timing. Let’s look at a couple examples.  First is based on accounting jargon called Revenue Recognition that essentially says that revenue should be recorded in the same period that you do the work.  As a creative, if a project is worked on and delivered in August, this would be considered revenue in August and thus part of August’s Net Income.  However, we know that in the real world, some customers do not pay us on time, taking weeks or months to cut a cheque, while shamefully, a few don’t pay at all.

 

To amplify this cash flow challenge, consider those projects that require subcontractors to get the project done; either for their specific expertise or simply to manage the workload and timelines.  It would be wonderful if all subcontractors would patiently wait to be paid when the client finally pays their last invoice.  While some do, we’re advocates of being paid promptly for the work you do; this is food on your table and the onus of responsibility to manage the timing of cash inflows and outflows is on the person or firm who owns the project.  Also, the more a subcontractor is used for his or her rare and specific skillset the more he/she is able to demand prompt payment…and should. This puts you in a position to pay your bills on time but often wait to receive full payment for weeks or months.

 

In addition to these project flows, you must also consider cash outflows that don’t show up in your income statement. For example, if you took a loan to fund your business, the loan payments must be paid out of your monthly cash flows and aren’t calculated as part of net income. Only the interest becomes an expense. Also, if you have taxes outstanding or coming up for payment, this can also be a surprise to the bank balance and very difficult to plan for.

 

The combination of these elements can present significant cash flow challenges – even for a profitable business.  You can’t rely on profitable projects alone to build your bank balance.

 

 

2. A Company’s Annual Financial Statements Tells You Very Little about Its Operating Performance:

We saw in the above example of how a profitable project can lead to cash flow challenges based on the timing of cash flowing in and out of the business.  Multiply that by several projects that overlap throughout the year and this creates quite a challenge in managing cash flows.  The important point here is that your annual financial statements tell you next to nothing about the flow of your operations throughout the year.  In business and entrepreneurial life the path between two points has many ups and downs.  You may have started the year with healthy accounts receivable and bank balance, hit a serious 3 month cash flow crunch, and ended the year with healthy financial statements. This is a common occurrence and requires careful planning.

 

The Bank Balance is an entrepreneur’s life blood.  How can I get a handle on my cash flows?

There is both an art and science to managing and predicting cash flows.  Have a read of our expansion of this topic: How to Manage Cash Flows.  Here are a few suggestions that work well for our clients at Measure:

 

–          Maintain a list of open projects that are in various stages of completion with invoice amounts and dates clearly indicated.

–          Maintain a Sales Pipeline; a list of prospective projects you are hoping to win and a realistic probability of winning them. Map out expected close dates and understand the potential invoices dates.

–          Bill early, bill often – receive down payments and progress billing. Leave only a small amount (10-25%) for project completion.

–          Add a progress payment schedule to your contracts. For example: deposit on Aug 15th, progress payments on Sep 30, Oct 31, Nov 30 with final payment on project completion. This makes the payment terms very clear.

–          Squeaky wheel gets paid – follow-up often on your payments dues

–          Adopt an “F*&k You Pay Me” attitude – never, ever, ever feel embarrassed to ask for payment on your work.

–          Seek professional help. Mapping out your bank balance with a pro at least every 3 months is a good investment.

 

Awesome Co. shows us a real world example of how a company can have an attractive income statement showing a net profit on the year yet still face the cash flow challenges that can bring it to brink of bankruptcy.  Ultimately cash flow, those dollars flowing in and out of your operating bank account, and the art and science behind their timing is the key to nights filled with sleep instead of anxiety and the path to every entrepreneur’s goal: their business utopia.