Cash Receipts and Disbursements Not the Best Way to Determine Profitability
Speaking with entrepreneurs recently (especially those w/businesses that buy/sell inventory) I’ve noticed a lack of understanding of the difference between cash flow and net income, profitability.
Let me give you an example:
- Business selling inventory
- Start business by purchasing 10,000 units at $1/unit; total purchase = $10,000
- Sell 1,000 of those units for $5/unit; total sales = $5,000
Let’s stop here for a second. At this point, many of you might come to the conclusion that you haven’t made any money (profits). After all, cash spent ($10,000) exceeds cash received ($5,000 sales) and so your net cash flow is negative $5,000. This view of the facts doesn’t tell the whole story.
Let’s view the facts using simple accounting:
- Sales $5,000
- Less: Cost of Goods Sold ($1,000)
- Equals: Gross Profit $4,000
Some of you may be thinking how can I have gross profit when I’ve spent more than I’ve collected in sales? Good question! The reason is that you’ve sold each of the 1,000 units for more than you paid for them individually. The remaining $9,000 ($10,000 initial purchase less $1,000 cost of good sold) of inventory remains on your Balance Sheet as an asset. It is not “expensed” on your Profit and Loss Statement until the units are actually sold.
Assuming the inventory doesn’t expire/spoil (think produce or other food type products) then your $9,000 of inventory will remain at that value on your Balance Sheet and will be “costed” to the Profit and Loss Statement at $1/unit.
My point is this. Having the proper understanding of accounting for sales, inventory and cost of goods sold would lead you to better decision making. Let’s say these items are flying off the shelves quickly and you’re profiting $4/unit ($5 sales price less $1 per unit cost), you definitely would consider buying more inventory even BEFORE you’d recouped your initial $10,000 investment. Waiting until you recouped your initial $10,000 investment would cause you to miss profitable sales in the interim.
Above said, any credible accounting software that has an inventory function should be able to handle the accounting properly. I recommend Xero or QuickBooks (desktop version) to handle inventory and consult on either software.
I hope this simple example will help you gain an understanding the differences between cash flow and profitability. I’d love to help clarify the accounting to be used for sales, inventory, and costs of good sold.