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Laurie Owen: Master Hidden Logic of Profit

Highly seasonal sales patterns can make running a jewelry store a perilous affair. The key to survival is knowing how to measure cash flow.

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DO YOU REMEMBER HIGH school geometry and all those conditional statements? The “if then, then therefore,” logic strings? I bet you thought you’d never use them again. You thought wrong! Here’s one for you:

If sales do not necessarily equal profits, at least not in direct proportion, and if profit does not necessarily equal cash, therefore more sales do not necessarily equal more cash.

That doesn’t sound very logical, does it? But each of these statements is especially true for a business that has a seasonal sales pattern, lots of inventory and carries accounts receivable. Sound a lot like the jewelry business? You bet.

Sales and profits? I think we’d all agree that in any business, there has to be some relationship between sales and net profit, because to earn a profit, what do you first have to have? A sale!

Generally, in most businesses as sales go up, profits go up; sales go down, profit goes down. It’s a direct, but not proportionately direct relationship. Profits don’t rise and fall in necessarily the same proportion as sales. For example, if you end up spending a lot of money on advertising and staff to drive higher sales, those added expenses can cut into your profits.

Profit and cash flow? For many business models, profit and cash are typically two different things. Profit is something you make on a piece of paper (your profit and loss statement, or P&L); cash flow is what you have on your balance sheet. We measure profit on the P&L by matching the expenses incurred to the sales the expenses helped produce — using the accrual method of accounting. But the P&L tells us very little about cash flow. We measure cash on a cash-flow worksheet, using the cash basis of accounting — which tells us very little about profit.

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Sales and cash? In the jewelry industry, because of seasonal sales patterns there can actually be an inverse relationship between sales and cash: as sales go up, cash goes down; as sales go down, cash goes up.

Here’s why: In your typical jewelry store, as your sales go up, you’re buying ever-increasing amounts of inventory to support rising sales, and in some cases, creating ever increasing accounts receivable. At just about any point in time, as your sales rise, you’re investing cash into new assets (inventory and A/R) at a greater rate than you’re collecting cash from your prior or current sales. Cash is going out faster than it’s coming in, causing a financial gap (the difference between the cash you’ve got and the cash you need) to occur, which leads to increasing needs for short-term debt to fill the gaps.

As your sales go down, you’re collecting cash from prior credit sales and current cash sales at a greater rate than you’re reinvesting cash back into inventory and A/R. Cash now is coming in faster than it’s going out, resulting in cash surpluses, which allows you to repay short-term debt.

This is a classic example of a seasonal business. The store’s sales are causing cash either to rise or fall depending on which direction sales are going.

To further illustrate this point, can you have:

  • Positive profit and negative cash? Yes.
  • Negative profit and positive cash? Yes.
  • Negative profit and negative cash? Yes.
  • Positive profit and positive cash? Yeah – and what a great thing that is!

If you’d like your business in the last category, watch your cash, manage more efficiently, and set up credit lines before you need them to handle seasonal cash needs. Invest some time creating a profit plan (projected P&L) and a cash budget (projected cash flow) so you can measure and predict cash flow and profits. What gets measured tends to get managed better. Sounds logical enough, doesn’t it?

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For some simple and free worksheets in Word and Excel, visit brs-seattle.com/toolkit.html.

This story is from the June 2008 edition of INSTORE.

Laurie Owen was INSTORE's financial columnist during the first decade of the publication's history.

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