Simplified Accounting Limited - Keeping accounts simple

"Turnover is vanity, profit is sanity, cash is reality" ... what does this mean?

On Dragons' Den on Sunday night Hilary Devey said "Turnover is vanity, profit is sanity, cash is reality" ... to some a well known phrase, or a version of one and others will have sat there, looked at the TV and said "huh?!?".

So, what is it all about? As has been seen over recent years, established, long standing and well thought of businesses can and do fail and it always comes down to cash, or to be more precise, a lack of it. 

So, what does it actually mean .. how can a company be profitable and not have cash? 

In basic terms one business model is 'buy stuff, sell stuff". The "stuff" is better known as stock and has to be paid for.  Depending on where the stock is purchased you will hopefully have a grace period between receiving the goods and the invoice and having to pay for it (say 30 days).  Once you have purchased your stock and paid for it then you have spent this money without any income, it is only when you sell this stock that you make any money (sale price = turnover) and it is at this point that you make your profit (sale price - cost of stock = gross profit). 

If the period of time between buying your stock and selling your stock is short then your cash isn't tied up for too long, however, if you buy lots of stock and keep building up the stock you hold then your cash is tied up for longer and longer before you sell the stock again.  During this time, cash gets tighter and tighter as until you sell the stock there is no money coming in for all the other bills.  If you are not careful you can find that you have run out of cash and this is when problems can start.

As cash gets tighter businesses look for alternative forms of funding i.e. loans and then as well as having cash tied up in too much stock there are the loan repayments to make ... and so the circle goes until at some point the bubble bursts and the realisation hits that although sales are being made and profits are being made there is in fact no cash!

So what is the message to take away from this?

  • Control your stock levels, don't let them get too high ... you need enough to meet your sales but not enough for the next six years! 
  • Get your pricing right so that you actually make a profit and cover all costs
  • Don't tie up all your cash in stock .. ensure you have cash enough to meet your on-going bills.

Okay, so this is a simplified version of a businesss and there will be other costs to be covered and there are other types of business but hopefully you understand more than you did at the start of this blog.

If you need help with budgeting and cost management then talk to us to see how we can help.