Tag Archives: cost of goods sold

Empty Wallet

How can a startup be profitable & still run out of cash?

New entrepreneurs often confuse profit and cash. Understanding the difference can be critical to your success. After all, it is possible for your company to be profitable and yet still run out of cash. And it is even possible to be unprofitable and have plenty of cash.

Making a profit is one good indicator of whether or not your company is successful. Having cash determines whether the company will be alive, i.e., whether the company will survive so it can be successful or unsuccessful. To help you understand the difference, let’s examine the two concepts.

1. Profit

Revenue (aka sales) is what you record on your financial books when you sell a product or service to a customer. For example, if you sell a 2,000 bottles of wine for $25 each to customers during a month, you record $50,000 in revenues for that month.

If it cost you $10,000 to produce those bottles of wine (by the way, that’s called cost of goods sold) and you paid rent and salaries during the month of, say, $25,000 during that month, your profit for the month will be $15,000, i.e., subtract your cost of goods sold and expenses from revenues.

2. Cash

A company can gain cash in four ways:

  • By receiving payments from customers when you sell them products/services.
  • By receiving payments from lenders when you apply for a loan.
  • By receiving funds from investors.
  • By receiving cash for selling fixed assets. [Very rare for a startup company]

A company can lose cash in a variety of ways:

  • Cost of goods sold or expenses. By making payments to suppliers.
  • By making payments to lenders on a loan.
  • Stock repurchase. By the company returning outstanding stock back to the treasury. [Very rare for a startup company]
  • Buying assets. By paying cash for the purchase of fixed assets.

3. How Cash Can Exceed Profit

Many scenarios can demonstrate how you can be unprofitable and yet have cash. Let’s look at some. In all the following cases, assume that at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

  • If you have negotiated “net 60” terms with your suppliers, you will still owe them $35,000 and you will end up with $50,000 in the bank at the end of the month (even though you had a profit of just $15,000).
  • On the other hand, if you took out a loan during the month of $40,000, you will end up with $55,000 in the bank at the end of the month.
  • On the other hand, if you accepted an investment during the month of $200,000, you will end up with $215,000 in the bank at the end of the month.

In all these cases, your profit is $15,000, but your cash was quite different, specifically, $50,000, $55,000, and $215,000, respectively.

4. How Profit Can Exceed Cash

Many scenarios can demonstrate how you can be profitable and have much less (or even no) cash. Let’s look at some. In all the following cases, assume that at the beginning of the aforementioned month, your checking account had a balance of $0 (which might be the case if you just started the company). Let’s again say you sold 2,000 bottles of wine for $50,000 and made a profit of $15,000.

  • If 500 of those bottles were sold to a customer that had negotiated “net 30” terms with you, that customer will still owe you $12,500 by the end of the month (by the way, that’s called your accounts receivable). You will have only $2,500 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you still owed $1,000 to a cork supplier from a previous purchase you had made (by the way, that’s called your accounts payable) and decided to pay it this month, you will have just $14,000 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you decided to purchase a major piece of equipment for $10,000, you would be unable to subtract that amount from your revenues, but you would have to spend the cash. Thus you’d have just $5,000 in the bank at the end of the month (even though you had a profit of $15,000).
  • If you are a B2B company, and your customers (who are businesses themselves) are having cash problems, as is often the case during difficult economic times, so they may delay their payments to you. If half of your customers have failed to pay you by the end of the month, you will have $25,000 less than you expected. That means you will end up with a negative balance in your checking account, something that banks frown upon. Before long, you could be out of business.

In all these cases, your profit is $15,000, but your cash was quite different, specifically, $2,500, $14,000, $5,000, and minus $10,000, respectively.

In summary

The difference between cash and profit is not subtle. Many companies have been forced out of business due to lack of cash even though they were profitable. Understanding the difference and planning ahead is essential to prevent disasters.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?  If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

Many pricing strategies for the entrepreneur

In earlier posts, I have discussed how differentiation and lowering your costs may affect pricing strategy. I have just a few more com­ments to make about pricing strategies:

  • Penetration pricing strategies. In early stages of a start-up, you need to convince your­self and others that you are viable and scalable. If the only way you can sell product entails losing money on every sale (i.e., price does not cover cost of goods sold), your company is a non-starter. So, make sure you do not set prices below cost of goods sold in an attempt to penetrate the market. So called penetration pricing rarely works for start-ups.
  • Covering your fixed costs. Let’s say you can capture sales from com­pe­ti­tors by under­pricing them, and your price is higher than your COGS, so you do have positive gross profit. Make sure you under­stand the sales volume you must achieve in order to cover all your other (fixed) expenses, so the company can achieve break­even. If raising the price slightly is necessary to make you profitable, but reduces your sales volume and thus makes you unprofitable, you may need to adjust other assumptions (like your target market, your sales model, etc.), or you may not have a viable business.
  • The long tail. Made popular by Anderson [AND06], the long tail is a business strategy in which much of a company’s revenues relies on selling low-volume (perhaps customized, perhaps expensive, perhaps exclusive) pro­ducts to niche customers while simulta­neously selling high-volume (per­­haps low price, perhaps free, perhaps low margin) products. The claim is that if inventory costs are near zero (e.g., for storing music or software) and/or if customization costs are near zero (e.g., with the appropriate pro­prietary software in some cases or with mass customization in other cases), that selling small quantities of a very large number of unique products can be as profitable as selling massive quantities of identical popular products.
  • Low price as sole business strategy. Many companies, especially ones selling com­mo­dity products similar or identical to competitors, compete based on low price. The sec­ret to competing this way is to have lower costs than competitors. To have lower costs than competitors, you must either have a lower cost of goods sold (i.e., a cheap­er source of supplies), or lower operating expenses. As a general rule, a start-up is not going to compete with established companies with identical products and customer experience using just a low price strategy. You simply do not have the scale.
  • Dangers of low pricing strategies. Although no business stra­tegy is without pitfalls, relying on low price as your only strategy comes with a unique set of dangers: (a) you will likely have very small margins, so the slightest increase in your costs will make you unprofitable; (b) if you are new to entrepreneur­ship, you likely have missed some significant expenses in your cal­cu­lations; once those expenses appear, your low prices may no longer be feasible; (c) estab­lished companies struggle with cash flow all the time; even if you can remain profitable, you may not have enough cash to stay afloat; and (d) if you have in fact figured out a unique way to reduce your costs, what will happen when your competitors figure out the same way?
  • Low pricing as part of a business strategy. Just about every start-up that succeeds competes with a differentiation strategy (using some combination of unique products, better features, better customer service, more convenient shopping, etc.), and it may or may not offer low prices. Prices could be set low initially (to help convert early adopters) or could be set high if the value of the additional product or service is significant (see next paragraph).
  • Value pricing strategies. Value pricing means establishing a price for your product based on what you believe the customer gains as a result of having your product (regardless of what it costs you to produce the product). When you sell a product, you are making an ex­change of a product for $x of cash. You want two goals to have been fulfilled after the transaction:

–      Goal #1: You want customers to feel that they would rather have the product in their possession than $x in their pocket. This is the essence of value pricing.

–      Goal #2: You would rather have $x in your bank (and the happy customer in your list of customers) than the product in your inventory.

The above extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback formats at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE.