Cash Is King: Part I

The title of this blog makes me sound like capitalism's biggest fan. That's not the crux of this article...

There is a false misconception that profitable companies or individuals are financially healthy. Defined, profitability is your income less expenses; high profits either mean high income, or small costs.

Healthy...right? 

...lets reivew...

Example:

Income: Imagine I own a small company; I negotiate and agree an amazing 6 month contract, which pays me £24,000 for 6 months worth of work. I get paid at the end of the contract. As this is a 6 month project, I need to show that £24,000 in my accounts amortised over a 6 month period. I therefore put through £4,000 of income a month in my financial statements. I don't receive the cash until the end of 6 months.

Expenses: I also rent an office, and prepay the rent in advance every 3 months. Every 3 months I prepay £2,100. Again, as this amount is for 3 months in my accounts, I need to show £700 expenses every month. 

My accounts: for the next 6 months I would show monthly profitability of £3,300 (£4,000 income less £700 expenses). Healthy...right?

Reality: what the above example of profitability masks, is the failure to recognise cashflow. At the beginning of the first three months I have to pay out £2,100. Similarly with the next three months. I don't receive my £24,000 until after 6 months. In the meantime have had to spend £4,200 on rent; if I don't have this money aside, I cannot afford rent, for these 6 months, and I could go out of business. 

Cue...cashflow...

Cashflow Considerations:

The above demonstrates the importance of cashflow; this is the net of cash in less cash out. Cashflow describes and accounts for the flow of money; profit accounts for the flow of services.

Profit is important for many reasons; for listed companies it presents the option to pay dividends, or to help support fundraising narratives. Cash is the lifeline of any company, and is therefore, king. 

Technically, cash is probably queen, as queen on a chess board is far more important than the king...anyway, I digress. 

How does it apply to your personal finances?

Now that we have established the difference between cash and profit, we need to consider how they relate to personal finances. 

Your income, and your expenses affect your cashflow, rather than your profit line. Take the following examples: 

Credit Card / Store Card: In January, I spend £300 on shoes in the sales (a common occurrence); the terms of the card stipulate that I don't have to pay that card off until the end of February. While the transaction occurred in January, I need to have enough money in my account in February. 

Household Expenses: while credit cards, and loans tend to have a delay associated with repayment, and cashflow, household utilities tend to have upfront payments. Water, electricity, gas, TV licence etc all tend to be paid upfront before you use the service or good. Coupled with this, they are often estimates, and tend to be overestimated, rather than underestimated. You must make sure you have enough money in your account to cover the upfront costs associated with this cash out. 

Why is this important?

In general, managing cashflow is tricky. This is especially difficult after the holiday period (Christmas or summer) where most of spending tends to applied to credit cards, and thus is now a realised debt that needs paid down. 

All the above rolls up into your budgeting; making sure you have enough money set aside in the times that you need to pay it out versus when the activity occurs is core. For example: you want to go on holiday in August for summer. You will probably pay for your flights and hotel earlier in the year (to get good deals), and you may put your holiday spending on the credit card. You need to make sure you therefore have the right amount of cash to pay for the flights, and to pay off your credit card, rather than in August, when you go on holiday. 

While many people talk about profitability, you can see from the above that cashflow is fundamental in making sure you meet your expenses. 

In my opinion, cash is King.

Photo from the beautiful unsplash.com