Wednesday, January 12, 2011

The importance of managing cash-flow, profit and your balance sheet

When reading about the growth of many startups, I've often heard people talk about the importance of managing their balance sheet, profit and cash-flow. Most businesses struggle at the cash-flow end. They might be profitable, but they need to pay their costs up front while their customers pay them later. Take a traditional retail business. They'll need to source, buy and warehouse product then lease, fitout and staff a store before they even make their first sale. They constantly need to buy product first in order to sell it to customers second, even with great profit margins this cash-flow situation can be difficult to manage. Many profitable businesses have failed simply because they couldn't manage their cash flow correctly.

In the case of Shoes of Prey we're in the fortunate position that we receive payment from our customers first, then pay our suppliers after the shoes have been made and shipped. This is fantastic from a cash flow point of view. The situation gets even better in periods like the lead up to Christmas where we've sold hundreds of gift certificates. The gift certificates are paid for in advance then may not be redeemed until some months later.

It would be very tempting to see this money we have in the bank and go spend it on a fancy office or to experiment with a Shoes of Prey store, but while cash-flow is great, we need to keep in mind our profit and balance sheet. It's all well and good having cash in the bank, but when we look at our balance sheet we now have a liability equal to the cash we have in the bank for all the outstanding gift certificates we've sold. As those gift certificates are redeemed we'll be paying our suppliers without receiving additional payment from customers. The same goes for profit. Just because we've sold lots of gift certificates that are yet to be redeemed doesn't mean our profit margin has increased. If we just looked at our cash situation during December things look fantastic. But we need to remember that January and February will be quite different from a cash point of view, and despite the cash situation our profit margins haven't changed.

I may have thought those Management Accounting classes at university were an incredible waste of time, but those lecturers were actually on to something. :)

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  1. that's right the gift certs are a liability. i can't remember the stat but a lot of people don't redeem them. technically, its an unearned liability so you do the following accounting entries:

    DR Cash at Bank
    CR Unearned Liability

    When the cert. is redeemed:

    DR Unearned Liability
    CR Revenue

    It recognises the fact that you have received cash for a service that is yet to be performed (i.e. a prepayment). Then it is recognised as revenue when the service is performed (redemption).

    The accounting geek comes out! i was thinking about a blog post along similar lines titled "the relationship between sales and accounting". tbc.....

  2. Nice accounting geekiness there! To geek it up some more, we have to have separate cash at bank and unearned liability accounts for each of the currencies on our site. We also don't put an expiry date on the gift certificates because even if we had one, to keep with our high levels of customer service we'd allow customers to redeem it after it's expired anyway, so we figured we'd message that up front and wouldn't bother with the expiry date. That gets tricky for accounting though. We'll probably work out an expiry ratio for accounting purposes. Perhaps 50% of unredeemed certificates are written off at the 12 month mark, another 30% at 2 years and the remainder at 3 years. Haven't finalised that part yet, more geeking to come. :)