The first thing a person thinks about when starting a business is profitability; that is whether or not an enterprise set up can operate in the long run and generate tangible financial gains. In this process, an individual subconsciously puts thoughts in two things; the product and the customers. The first notion a person comes up with is product utility. This idea initiates the analysis of the product benefits that can be offered to customers. The following opinion becomes where to find the customers with the need for that product. In this course of action, where ideas start to flow, an individual decides to make a further commitment to the business.
In order to comprehend the terminology “Profitability”, we must first understand profit. Profit is the excess of revenue over expenditure. It is the remaining amount after all the direct, and indirect costs relating to a sold product are deducted. Profitability is simply the ability of a business to generate profit. Increase in profit over time indicates positive profitability to the business. In that manner, giving attention to that relationship between the two, profitability can increase either by boosting revenue or by reducing cost. Profitability can be used as a good indicator of business performance.
What is business performance? Well, intrinsically, if a business can achieve sales goals and meet its obligations in its life cycle, we tend to acknowledge that as business performance. A business obligation is a synonym for business liability. Ideally, these are outstanding bills from suppliers for the purchase of materials, goods or services. Business liability can also be provisional and due taxes and any other working capital like borrowing. Sales goals can be, an increase in sales quantity, decrease in customer credit cycle or generating new customers.
While profitability is a good indicator of business performance, it is not an exclusive one. Another measure of business performance is cash flow; the total amount of money that is going in and out of business. The fact that an enterprise can carry out credit sales and purchases shows that not all business profit is realized into actual money immediately. The concept is if the business is profitable but does not have enough funds to settle obligations at a given point in time, then the performance becomes impaired.
Let's take an example XYZ Company is a producer and seller of candles. They purchase their paraffin wax raw-materials from ABC Company with a credit term period of 30 days. The cost of raw-material and labour per candle is $150 and $10 respectively, and the selling price is $300. In a month, XYZ Company produced and sold 100 candles leading to a revenue of $30,000 and the total cost of $16,000. XYZ Company collects 20% of the income as cash and the remaining 80% as credit. In this scenario, XYZ Company makes a profit of $14,000 and a cash of $6,000.
In profitability perspective, XYZ Company has performed very well as it is able to gain a profit of $14,000. Now consider this situation, at the month-end ABC Company decide to exercise their credit terms, and they demand their cash for raw-materials which is $15,000. XYZ Company can only pay $6,000 at best, excluding the labour cost that also awaits them. ABC Company refuses to issue further raw-materials until their debt gets paid in full. For XYZ Company no raw-materials means no production, no sales, no revenue and no profit. In this case, we can argue on a going-concern basis that XYZ Company's performance is impaired.
Given the above example, it is very concise that any business must focus on liquidity as much as it focuses on profitability. Profit is a long term indicator of achievement, and cash flow is a day to day measure of performance. An enterprise must assess their ability to generate cash and their capacity to employ it efficiently. An insufficient cash position makes it impossible to settle business obligations, and excessive cash position leads to a negative return on assets as that fund should have been used for investment and business growth. Exploring the relationship between profit margin and cash flow margin can help to build up more understanding of the idea.
Profit margin arrives by taking a profit over total sales. An 80% profit margin means that for each dollar of sales, 0.8 dollar is profit, and in other words, 0.2 dollar is the cost of sales. A business can interpret profit margin from gross profit, operating profit or net profit level. The gross profit comes after the subtraction of the cost of sales from revenue, and operating profit arrives after deduction of operating expenses. Net profit is the excess of income above all business expenses along with administrative cost and tax. Cash flow margin is the amount of money generated from a single unit of sales. 80% cash flow margin implies that for each dollar of sales, 0.8 dollar is cash sales and 0.2 dollar is credit sales. The calculation for cash flow margin is cash receipt from operations over revenue. Cash flow margin shows how efficiently a business converts sales into cash, and it is a good indicator of liquidity performance. In evaluating business performance, profit margin analysis should go in hand with cash flow margin interpretation.
A healthy cash flow margin for any business is two-third of the gross profit margin and one-third of operating profit margin. For a gross profit of 50%, an enterprise needs at least a cash flow margin of 33%. It essential to ensure that the business meets both short term and long term obligations on time. Any business can achieve a healthy cash flow by having clear sales goals and cost maintaining system. If the business entity has a credit term of 30 days on purchases from its suppliers, it should also have a credit term of 30 days on sales to its customers and not a day longer. Business expenses must be assigned to ensure that funds proceed to significant expenditures that facilitate basic business operational requirements rather than auxiliary cost.
In conclusion, profit and cash positions are both fit indicators of business performance. Positive profitability indicates signs of business growth that a business can achieve through the investment of profit and liquidity is a good indicator of business sustainability. Additionally, this article has not covered wide aspect on key areas of profitability and cash flow, although it has provided light on meaning, significance and comparison between the two terms, a deep dive is required for further understanding of the terms. The points like how cash flow from operations is derived or what is operating cost in business are not covered and thus require further reading.
By Adam Kamulika on 17 May 2021