Previous articles have focused on giving the business structure and dimension. Those same articles have foreshadowed the requirements for financial projections.

The operational answers and plans that have been a result of previous discussion and exercises are the basis for capturing the financial implications of your activities, both as expense and cash demands on the business. By taking time to define the conceptual vision, you begin to capture both the operational realities and the financial needs of your business.

There is an important distinction between profitability (revenues and expenses) and cash that often gets lost in the analysis of business results and projections. There has traditionally been a heavy concentration on the profitability of businesses and rightly so. However, there is an equally (if not, at times, more important) aspect of the business: CASH. Cash is the life blood of the business and is a critical item to forecast accurately.

When businesses are established they have the option of accounting for their business on a cash basis or an accrual basis. Cash basis is just that: when you receive cash or spend cash, the transaction is recorded. Accrual basis is when the business records the revenue due and the expenses to be paid at the time they are incurred (product purchased or sold), and reflects the transaction and activity period, not the timing of cash being paid or received.

Both cash-based and accrual-based businesses have to maintain appropriate levels of cash to pay current demands. Regardless of the accounting methodology, the business is subject to the constraints imposed by the ability to generate cash, also called working capital. The cash flow cycle of a business is comprised of several elements that differ somewhat based upon the nature of the business. In the planning stage, businesses need to understand the impact of the cash cycle and its impact on working capital/cash.

The cash cycle works like this. The business needs to provide products or services. In order to provide those products or services the business acquires: inventory, people (wages), and other services, equipment, etc. necessary to the "production" and sale of the product or service to a customer. The terms of these purchases—how and when you are going to pay for the inputs—impacts when you will have cash needs. If you have to pay cash on delivery or at the store, then you have outflow or reduction of your cash balance. If you can delay payment to 30 day terms, then you have an outstanding liability that may or may not be on your books (cash versus accrual accounting). How long it takes you to convert the "inventory" into a sale and then collect the cash from the sale tells you the number of days in your cash conversion cycle.

Example:

Let’s use a retail store selling home accessories, starting the business with $2000 cash on the first of the month. You purchase 100 items for the store for $1000 cash. The price of each item in the store is $15. Over the course of a month you sell 50 items; you have taken in $750 in cash. You sell another on 20 on 30-day terms at the end of the month. You have revenue of $1050; you have cash of $750 from the sale. At the end of the month, your cash position is $250 lower than when you made the purchase at the beginning of the month. $2000 - $1000 +$750 = $1750. [Accrual base profit = ($15 X 70) - ($10 X 70) = $350]

If you want to keep 100 pieces in inventory, you need to purchase 70 more items or $700. Cash is now $1750 - $700 = $1050. At the end of month two, you collect the cash for the prior month’s credit sale (70 items), $700. You sell 20 items for cash during the month and 80 on 30 days credit. Cash position is $1050 + $700 + $300, or $2050. You purchased an additional 100 items, so you are now back to $1050 in cash. Revenue and profit under accrual basis is 200 units X $15 or $3000; profit is 200 units X $5 = $1000.

As you can tell from this example, the difference between cash and profit are significant and the decisions you make differ based upon the perspective. The impact on cash of the terms you receive from your vendors and those that you extend to your customers, combined with the level of investment in inventory and other inputs, is critical to understanding what the financing and operating implications are in your business plan, especially once you are operating your business.