B^3 #3: Path to Cash is King
I often challenge new hires or those just starting out in business with a simple riddle:
In your first year, you sell $100 worth of goods. The cost of producing those goods is $50, and the overhead (wages, storage, picking, packing, and shipping) adds another $20. By year’s end, your inventory is depleted, so you need to restock at least the same amount of goods. Did you make any money?
At first glance, the IRS would certainly think so. According to them, taxable profit is calculated as sales minus the cost of goods sold (COGS) and expenses—leaving you with $30 of "profit." So, you'll owe around $12 in taxes (assuming a combined federal and state tax rate of about 40%).
But what about your cash flow? After all, in business, what you can "bank" is what really matters. Cash flow represents the lifeblood of your business—how much free cash you generate from profit that can be used to reinvest, pay down debt, or, quite literally, keep the lights on.
Let’s break it down by constructing a simple cash flow statement. We’ll assume you start with zero dollars in savings and just inventory.
Starting Balance: $0
Sales Revenue: +$100
Cost of Goods Sold: -$50
Operating Expenses: -$20
Profit: $30
Taxes: -$12
Inventory Replenishment: -$50
Deposit to Bank: -$32
That’s right—after all your hard work, you're $32 in the hole. Ouch. It stings, but it’s a critical lesson: positive profit doesn’t necessarily mean positive cash flow.
This oversimplified example helps illustrate the fundamental truth about cash flow and its role in the success of a business. While your profit and loss (P&L) statement tells you whether you're theoretically making money, your cash flow tells you whether you're actually solvent.
Gross Margin: The First Line of Defense
One of the first factors to examine in your business is your product’s gross margin. Gross margin is calculated as **(Price - Cost) / Price**, and it shows how much of each dollar of sales is profit before overhead expenses are factored in.
If your gross margin is below 40%, you’ll struggle to achieve profitability. On the other hand, a margin above 65% makes it much easier to generate "bankable" money. Gross margin can often make or break a business, especially when it comes to absorbing the various expenses that chip away at your profitability.
Cash Conversion Cycle: Timing is Everything
Next, consider how quickly you get paid after making a sale. In e-commerce, payment is typically swift, especially with credit cards. But in distribution, payment terms like “Net 30” are common, meaning your distributors have 30 days to pay after the invoice is issued.
Cash flow management is about more than just profitability; it’s about timing. You need to ensure that your cash inflows (from sales) happen faster than your cash outflows (expenses, inventory replenishment). Harvard Business Review often discusses the importance of this "cash conversion cycle," noting that businesses with shorter cycles are more agile, able to reinvest quickly, and are less dependent on external financing.
Why Cash is King
“Cash is king” because of the flexibility it offers. With more cash in hand, you have more control. You can negotiate better payment terms, invest in growth opportunities, and—perhaps most importantly—retain independence. If a bank offers you unfavorable terms, you can tell them to "pound salt" because you’re not at their mercy.
The magic lies in ensuring that your total assets (cash, inventory, receivables) are at least twice your liabilities. This "2:1 rule" offers a cushion that lets you weather the unexpected, whether it’s a slow sales quarter or a sudden need for a big capital expenditure.
Pro Tip for Personal Cash Management
One last piece of advice that applies to both business and personal finance: unless it’s your home, if you can’t afford to buy something twice with cash, think twice about whether it’s a need or a want. Harvard Business Review often underscores the value of disciplined spending, and this principle applies universally. It’s a simple yet powerful litmus test that can save you from making impulsive financial decisions that strain your liquidity.
In the end, cash is what gives your business—and your personal life—the freedom to make decisions on your terms. Focus on building your cash reserves, maximizing your gross margins, and managing your cash flow efficiently. That’s the true path to success in business.
- Ben
