Updated: May 2
There are a number of misconceptions regarding income in the business that can really cause a lot of problems and even lead to businesses failing and folding. Sometimes the problem is simply that people don’t know the difference between revenue, profit and cash flow, whilst for others, it is not being aware of the importance of all 3 of these figures. One of the greatest misconceptions is that cash flow is the most important, and yet a business can have a good cash flow and still not make a profit which will eventually mean that they will go out of business.
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So what do these different terms mean?
The term revenue is used to describe all of the income that comes into your business BEFORE you take off any of your expenses. That means all the money from sales as well as other income such as interest that you get from banks or other royalties. It is worth remembering that sometimes you may have received assets, goods or services that count towards revenue. For example, if someone paid you with their services instead of in money that may count towards your revenue depending on your tax laws. Or perhaps you received some other resource that has a monetary value that needs to be recorded down in your accounts such as a piece of equipment. You will need to check with your own tax laws and seek the advice of an accountant if need be.
The bottom line is that anything you receive for your products and/or services, and any other form of income that your company receives, is revenue.
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The term profit on the other hand is used to describe the total figure left AFTER you take away your expenses from your revenue. Those expenses could be for a whole host of things including materials, wages, rents and other rates, accountancy fees and much more. Remember, not only do tax laws change from country to country, but they are also different depending on the business you are in, and whether your income is subject to income tax or capital gains tax. If your business earns revenue from both sources of income then you may need to record these figures down as 2 sets of accounts. You would need to seek advice from an accountant to see what expenses you can and can’t claim in your business, and which sort of tax your business is subject to – assuming you are making a taxable profit. And also remember that the profit is the figure that will be taxed! You don’t take your tax off first and then work out your profits.
So for example, if your company earned £100,00 in revenue last year, and then you spent £10,000 on materials, £25,000 on rents and rates, £5,000 on other allowable expenses, and £20,000 on a salary for 1 member of staff, then you are left with a profit of £40,000 which is your taxable income.
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Cash flow is often seen as the most important figure of the 3, and although that is incorrect it is understandable why. Cash flow is exactly as it sounds, the cash flowing in and out of a business at a specific point in time. It is not as much the figure you currently have sat in your account, although that definitely is factored in, it is a measurement of how much cash your business has coming in and going out during the set period of time you are monitoring. That means you can have a positive or negative cash flow. You will need to decide the regular time period that you need to monitor, but generally, it is done on a monthly basis as that’s when invoices, rents and wages are paid. The reason behind this is to make sure that you can pay your bills and see if you have any left at your disposal.
Although you may do your cash flow calculations on a month to month basis, it could turn out that you then do a bi-monthly, quarterly or even a half-yearly calculation as well depending on when you receive your income. The reason is that you may have to pay out every month but you don’t receive the income on the same regular basis. This is where your bank balance comes into play, or for some the size of their arranged overdraft, as you will need to make sure that you can still operate as a business whilst not receiving any income.
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All are Equally Important
What may have become evident already is that all 3 of these are very important. Most that start out in business think that it is all about profit, whilst others struggle to distinguish between revenue and profit in the first place as they forget that there are other business expenses that have to be factored in. Others fall into the common trap of not making sure they have a positive cash flow, and whilst they have plenty of work booked in, they are unable to operate because they can’t pay their staff, rates or their invoices for materials.
Of course, it goes without saying that a business that isn’t earning a profit won’t last long, and we don’t want to put all those hours of work in for no reward. But having a forecasted profit of X amount doesn’t mean anything if you can’t deliver the services or supply the products. That is why cash flow is so important and it is why it is often seen as the most important of these 3 figures. But the reason that is wrong is that you can’t have good cash flow without having regular revenue coming in. And that revenue needs to be equal to or more than the expenses you have going out in that time period.
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Let's look at this example:
You have acquired a new customer who wants an order of 10,000 handmade coffee mugs. You have quoted them £5 per mug so that is £50,000, but they only pay you that money once you have finished the product and are ready to deliver them. Now let's say it costs you £2 in materials to make those mugs and it will take you 6 months to make them. That means for materials alone you will have to pay out £20,000 over the course of those 6 months before you get paid, plus any other expense such as your wages, insurances, workshop space and bills such as gas, electric and water. If that all comes to another £15,000, then you will have been paying out £35,000 before you received your £50,000 income from this job.
If you don’t have £35,000 in the bank to start off with, or other revenue coming into the business over that period of time, then you will not be able to deliver the mugs to the customer which will mean you won’t be getting paid. What makes it worse is you may have already paid out some of the money which means you are actually at a loss. That is why understanding what revenue you have coming in and when it is coming in is imperative. So many people just look at the profit margin and forget that to earn money sometimes you have to spend some first.
By evaluating your current cash flow you can make a decision about which jobs you can and can’t take on, and/or you could decide to stipulate a particular payment plan to make sure that you can still function during the time that you are manufacturing their product. So with the example above you could have asked the customer to pay a percentage upfront to cover some of the costs. At 20% they would have to pay £10,000 upfront, and although this wouldn’t cover the full £35,000 needed over those months, it would be enough if you had £10,000 in the bank and another £2500 coming in every month from other regular customers.
By making sure that you have good cash flow doesn’t mean that your job is complete because as I have already mentioned you will want to be making a profit come to the end of the financial year. Sometimes when starting up in business you may find that you initially make a loss as you have to pay out for lots of different things, but it is still possible during those times to have a positive cash flow. But eventually, you need to be turning a profit otherwise the floor could fall from beneath you at any moment if your revenue starts to dry up. It is always worth putting some of the profit aside for those rainy days when the revenue is low or no existent so that you can make it through and keep afloat.
I really hope that you have found this blog helpful. Understanding the difference between these 3 terms and why each of them is important is imperative in business. Whilst some have had to learn the hard way, it is far better to be aware of all of your business financial figures so that you have more chance of success. If you have then why not subscribe to the blog and the newsletter so that you get all my latest updates, offers and any other exclusive content, and please like the blog and share with anyone you think will benefit from it. If you have any questions, have found anything particularly useful or if you just want to connect, then please put your comments in the section below or contact me via social media.
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