Profitable but Broke: Is it Possible to be Both at the Same Time?

Is the net profit the only number you need to look at?

By Marwan Faddoul, Managing Partner, NFG Consulting LLC

There is a common saying in business, "cash is king." Cash is paramount for its multiple uses in running a business-from investing in plant and property as the business is kicking off, to paying dividends to investors as they seek a return on their investments.

When people want to know whether a company is running well or not, checking the company's profit is one of the easiest and most common way. This raises an important question: is it always a reliable way?

To answer this question, I will share with you the following story.

A tale of hard work

A very smart and hard-working young man decided, after working for 5 years for an international company in Beijing, to go back to his home town and open his own company. Blood, sweat and tears: a company is built.

He opened a company that produces top quality wool sweaters. After two years of hard work the company started to make money, and little by little it became very profitable. Suddenly the company went bankrupt. The young man, outraged with the situation, started to wonder what went wrong. And the only question he had in mind, when two officers from his bank came for the last time to take over all his company's assets was: how did this happen to me?

Understanding what went wrong

While he is grieving, let us help this young man find the reason for his issue from a financial perspective.

Looking at his company's income statement, the company's net sales increased year by year, a signal of business expansion. And the trend of net income is in line with the growth of the company's net sales.

Overall, we might easily come to the conclusion that the company is making a positive return, and that if expenses are controlled properly (in proportion to the growth of sales), there is nothing to worry about and a bright future is just around the corner.

However, positive (or even growing) net income is not a sufficient indicator of healthy situation. In essence, it is a figure that indicates how much money you may have made once cash from all sales contracts has been received, and cash for all expenses incurred has been paid (and after certain adjustments to plan for the future which we will not cover here). Yet, in real-world business, a considerable proportion of sales are credit sales—a contract that mandates a future payment-which do not turn into cash until the promised date comes. If the company is too aggressive in sales expansion, and especially if part of this aggressiveness involves extending the credit term of sales contracts, it will have to tie up a lot of cash to cover the period of cash collection from customers. As a result, the more it is selling, the tighter its cash situation.

As though this were not enough, when the company manufactures the product, it has to pay money for raw materials and direct inputs before getting anything from the clients. Assuming that the manufacturing process takes an average of twenty days, he needs cash to cover an additional twenty days of expenses per item produced.

Going back to our story, it is true that the young man's company was making a profit on each sale, and it is also true that their profit increased faster and faster. And he was quite encouraged by those two facts to expand his company, in other word, to produce more. Meanwhile, he was paying money to suppliers and covering his company's daily operation from the company's limited supply of cash, before getting anything from his customers. This corresponded to a total period of 50 days divided into 20 days production and 30 days credit for customers, which the young man was obliged to cover before earning anything in return. Soon, his company reached a point where it was short on cash and unable to support its production process.

Knowing that he would be getting money from customers, the young man took a loan from the bank and spent it all on producing more goods. However the underlying problem was still there. As a result of growing sales, he needed more and more cash. He was unable to pay back the bank.

As you can see, as long as his company's sales kept growing too fast, borrowing money from the bank simply fueled the problem. The young man put his company in a cycle that took his company into bankruptcy.

The lesson is that even a profitable company must be careful to match cash inflows and cash outflows.

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