Is a profitable business necessarily a prosperous one?
Posted by email@example.com on July 3, 2018
Financial terminology is used almost universally to provide numerical information on various aspects of a business – from profitability, health to direction. One of the most popular metrics used to decide whether an investment should be undertaken is the Return on Investment (ROI). In simplest terms, ROI measures the gain or loss generated on an investment relative to the investment’s cost and is calculated as a benefit over cost percentage. Much as ROI provides a reasonable frame of reference or decision-making process, its inherent limitation is in its oversimplification.
The one mistake that many business owners make is to confuse cash flow and profit. It is entirely possible for a profitable business to go bankrupt, and this is because cash flow and profit are two terms that represent different financial parameters. Profit appears on the balance sheet and reflects the surplus after total expenses are deducted from total revenue. It looks only at income and expenses at specific points in time. In contrast, cash transactions show on the cash flow statement and reflect the amount of available cash currently on hand as a result of inflow and outflow of money. Cash is more dynamic as it takes into account the movement of capital and is, in truth, more aligned with reality.
So why is it possible for a profitable business to go bankrupt? Business is profitable so long as the product sells for a higher price than its cost of production. This does not take into account delays in invoice payments. In the (highly possible) event that material suppliers demand payment before customers pay their invoices, the business would be plunged into a negative cash balance and, in the worst-case scenario, possible bankruptcy. Conversely, a company could be pumping in more money to maintain a positive cash flow even if per-unit cost has exceeded break-even point and the business is no longer profitable. Since cash is imperative to daily operations, meeting payroll, purchasing inventory, and other short-term financial obligations, it is arguably more prudent to use cash as the key indicator of business health, rather than profits.
To check how your organisation match up with others in the same industry, you can use SSON Analytics’ proprietary Metric Intelligence Hub™. This first-of-a-kind benchmarking tool houses country and industry-specific benchmarking datasets generated in-house using a productivity efficiency benchmark model (CICI-PEB) which is unique and proprietary to SSON Analytics. You can filter by country and by industry to access accurate, proven benchmarking metric data across individual metrics. Some useful metrics to check with regards to your cash flow are Days Sales Outstanding, Number of Business Days to Resolve an Invoice Dispute Case, Ticket and Paid On-Time Rate.
When placed in this perspective, it seems that the financially enlightened thing to do is to take a hard look at all balance sheet items and reevaluate them as cash transactions. This method of calculating ROI would indeed prove valuable in aligning projections with reality more closely and enable your business to be not only profitable, but also prosperous.
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