There are business fundamentals that are common to each and every business – and at the heart of every situation is the importance of profitability and cash flow. It is vital to understand the difference between them and that profitability and good cash flow do not necessarily go together.

Profitable businesses can go out of business because of cash flow problems.

So what is profit and what is cash flow?

“Profit” is what’s left over after you’ve paid all your expenses. This is nothing you didn’t know before. The important thing to note is that profit is “what’s left over”. PROFIT IS A RESIDUAL. It is a consequence of what happens in and to your business. Some of these things are within your control and some of them are outside your control. If you’re going to have any effect on your profit, you have to focus on those things over which you have control.

So what are they?

To answer this question, it is helpful to understand that there are only four specific factors that determine profit. These are:

1. the PRICE you charge for the products and/or services you sell.

2. the QUANTITY (or volume) of products or services you sell.

3. the costs you incur directly in producing or buying the products and services you sell. We call these VARIABLE COSTS because they increase or decrease as your sales increase or decrease.

4. the costs you incur whether you make any sales or not. These are called FIXED COSTS because they don’t change with changes in sales volume, at least not on a day-to-day basis.

Let’s use an example to put these four factors together.

Suppose you sell a product called a widget. It costs you €60 which is the variable cost and you sell it for €100 (this is the price).

If you sell 100 widgets (the quantity) the variable costs will be €6,000 and if you sell 50 widgets the variable cost is only €3,000. It varies directly with your sales volume (or quantity).

Now, if you sell a widget for €100 and it costs you €60, then you’ve made a profit of €40 on each sale. This is the gross profit or gross margin.

But you still have to pay your fixed costs to end up with your net profit.

If your fixed costs for expense items such as rent, leases, insurances etc are €3,000 and you sell 100 widgets and make a gross margin of €40 on each one, then your total gross margin is €4,000 and after deducing your fixed costs of €3,000, you will end up with a “net profit” of €1,000. The “net profit” of €1,000 is “what’s left over” after deducting the variable costs of €6,000 and the fixed costs of €3,000 from your total sales of €10,000.

On the other hand, if your fixed costs are more than €4,000, then you’ll incur a loss.

We can restate these factors in the traditional Profit and Loss Statement format:

SALES (Quantity X Price) €10,000

100 widgets at €100 sale price each

Less

COST OF SALES (Variable Costs) 6,000

100 widgets at €60 cost each

Gross Profit 4,000

100 widgets at €40 gross margin each

Less

FIXED COSTS (Rent, leases, wages, insurances, etc.) 3,000

NET PROFIT (what’s left over) €1,000

The Net Profit is the Resultant Figure from the Sales less Variable Costs less Fixed Costs….. and we have some control at least over each of these items.

Profit can be affected by focusing on those things over which you have control.

Any profit improvement strategy must focus on either or both of two things:

1. achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs

and/or

2. achieving greater sales per dollar of fixed costs by increasing the sales volume and/or reducing fixed costs.

So that we can put everything into perspective, let’s consider the profit improvement potential that would arise from a modest improvement in each of the four factors. We’ll use the previous example as a base and assume a 5% improvement in each of the four factors.

BASE CHANGE/ RESULT

IMPROVEMENT

Price €100 5% increase €105

Sales Vol. – units 100 5% increase 105

SALES €10,000 €11,025

Less:

VARIABLE COSTS €6,000 5% decrease €5,985

(€60 each) (€57 each)

Gross Profit €4,000 €5,040

Less:

FIXED COSTS €3,000 5% decrease €2,850

NET PROFIT €1,000 €2,190

It is evident that a relatively small % change in each of the four factors has a staggering effect on the resultant profit.

In the above example, a modest 5% improvement in each factor without a consequential unfavourable impact on each of the other three would more than double your profit from €1,000 to €2,190.

This is a 119% improvement in profit and from only a 5% improvement in each of the factors that affect profit.

You may want to take issue with the assumption that there are not consequential impacts on other factors.

But, it is a fact that small improvements made to each of the four factors that determine your profit will combine to give a staggering overall impact.

And of course the reverse is also true. If you discount your price, allow your sales volume to fall, fail to control your fixed costs and let your variable costs get away from you, then you can destroy a once profitable business.

Now, it is easy to say you can control aspects of these 4 factors, but how realistic is this?

Let’s look briefly at one of these factor, sales, and how you can affect your sales.

It is necessary to first understand what makes up your sales.

Sales of a business, any business, is made up of 3 components:

THE NUMBER OF CUSTOMERS YOU HAVE

X

THE NUMBER OF TIMES THEY COME BACK

X

HOW MUCH THEY SPEND EACH TIME THEY COME BACK

For example, assume you have 10 customers who come back 10 times a year, and they spend €10 each time they come back.

Your annual turnover will be:

10 customers X 10 visits X €10 spent each visit = €1,000

Now, what if you can increase each component of your turnover by 10%.

You will have 11 customers who come back 11 times a year, and they spend €11 each time they come back.

Your turnover will be:

11 customers x 11 visits x €11 spent each visit = €1,331

It has increased by a staggering 33% due to a modest increase of 10% in each of the factors that make up sales turnover.

So if you are looking to increase your sales, you in fact have 3 different components to work on, namely the number of customers you have, the number of times they come back and how much they spend each time they come back. Each component has different strategies to increase the respective result and you may choose to work on only one component, any two of the components or maybe all three.

Again, the principle of relatively modest changes having a remarkable end impact is present. It reinforces the fact that you don’t have to do earth shattering things to your business to significantly affect the end result.

But you do have to measure what is happening so that you can evaluate the effect of any particular strategy or marketing initiative.

So you have Profit as the residual – it is what’s left over

But does that mean that if you have a €1,000 left over (profit), you will have €1,000 extra in the bank? Or, in other words, if you make €1,000, will your cash position improve by €1,000. Not necessarily.

This is borne out by two of the most oft repeated questions we hear asked by clients:

“If you say I’ve made €120,000 profit, where is it? I have trouble even paying my bills.”

OR

“Despite having a good year, I can’t even take enough money out to have a holiday.”

This is the confusion that arises from necessarily aligning profit with cash flow.

But why doesn’t profit and good cash flow go together?

Let’s look at the following example.

SMALL BUSINESS CO PTY LTD

PROFIT AND LOSS STATEMENT

SALES (Quantity x Price) €800,000

Less COST OF SALES €480,000

(Variable Costs)

GROSS PROFIT €320,000

Less FIXED COSTS €200,000

(after dep’n €10,000)

NET PROFIT €120,000

SELECTED BALANCE SHEET ITEMS

DEBTORS €130,000 (59 days outstanding)

STOCK ON HAND €160,000 (122 days stock turnover)

TRADE CREDITORS €50,000 (36 days outstanding)

Here is the situation. Small Business Co Pty Ltd has a net profit of €120,000. It has Debtors of €130,000 being an average of 59 days outstanding between the time of the sale and payment by the customers; Stock of €160,000 representing a period of 122 days average between time stock comes in and it is sold; and Creditors of €50,000 representing average payment to creditors 36 days after receiving the invoice.

Let’s assume 2 different operators now take over the business and operate it for 1 year achieving the identical profit, but each has different management systems resulting in different Debtors balances and Stock holdings at the end of the year. We’ll assume the creditors are basically the same as they don’t allow their payment terms to blow out.

SMALL BUSINESS CO PTY LTD

DIFFERENT OPERATORS, DIFFERENT CASH FLOW

CURRENT OPERATOR 1 OPERATOR 2

SITUATION

NET PROFIT €120,000 €120,000 €120,000

(after €10,000 depreciation)

Debtors – Amount €130,000 €164,384 €98,630

– Days Outstanding 59 75 45

Stock – Amount €160,000 €197,260 €118,356

Turnover – Days Outstanding 122 150 90

Creditors – Amount €50,000 €51,017 €43,235

– Days Outstanding 36 36 36

MONIES IN BANK

NET PROFIT FOR YEAR €120,000 €120,000

Add Depreciation – Non Cash Expense 10,000 10,000

130,000 130,000

ADD/(LESS) FUNDS OBTAINED FROM/(USED FOR):

(Increase) Decrease In Debtors (34,384) 31,370

(Increase) Decrease In Stock (37,260) 41,644

Increase (Decrease) In Creditors 1,017 (6,765)

CASH SURPLUS FOR THE YEAR €59,373 €196,249

Let’s look at Operator 1.

You can see net profit is the same as previously, and assume that is from the same sales, gross profit and overhead expenses.

But debtors have been blown out from being 59 days outstanding to 75 days, stock turnover has increased from 122 days to 150 days, but creditors have continued at the same payment rate – the creditors won’t allow slower payment.

And the surplus cash? It is not the €120,000 net profit plus the €10,000 non-cash expense item of depreciation added back resulting in an expected cash surplus of €130,000.

It is in fact a cash surplus of only €59,373 as Operator 1 tied up an additional €34,384 in providing finance to his debtors and €37,260 in holding additional stock, with a slight offsetting increase in creditors of €1,017 due to him carrying more stock at any one time.

So despite earning €120,000 profit after €10,000 depreciation, Operator 1 ended up with only €59,373 cash surplus for the year.

What about Operator 2?

Assume he too had the same sales, gross profit and overhead expenses.

He instituted processes to collect his debtors faster, thereby reducing his debtors from €130,000 to €98,630, or to an average of 45 days outstanding. He was also able to turn his stock over faster and thereby carried less stock at any one time. He is only carrying €118,356 worth of stock compared with €160,000. He is turning his stock over every 90 days instead of every 122.

And he is still paying his creditors every 36 days, but because he is turning his stock over faster and thereby carrying less stock, he is also carrying less creditors at any one time – he has in fact reduced his creditors.

Operator 2 also earns €120,000 profit for the year after €10,000 depreciation.

And he ends up with €196,249 surplus in the bank from the year’s operations.

So the same business with the same profitability operated differently ends up with a staggering difference of €136,876 in net cash surplus for the year.

Debtors, creditors and stock are not the only factors that can affect your cash flow.

CASH FLOW CAN BE INCREASED BY:

1. Earning Trading Profits

The more profit you earn, the greater the base or opportunity for increasing your cash flow.

2. Decreasing Your Debtors’ Days Outstanding

If you collect your debtors faster, your cash flow must improve.

3. Decreasing Your Stock Holding

If you can decrease the amount of stock you are holding without decreasing your sales, then you have less money tied up in stock – you have released cash into the business.

4. Paying Your Creditors’ Slower

If you pay your creditors slower, you will have use of your money longer – an effective increase in cash flow. But this may be offset by loss of favourable trading terms or losing your status with your creditors – be careful.

5. Injecting Capital Into Your Business

This is bringing in outside money into your business – an obvious increase of business cash flow.

6. Selling Buildings, Plant, Furniture

The sale of non-required fixed assets provides cash flow, as does the sale and lease-back of required fixed assets. Again, the long term picture must be reviewed in order to determine whether this is an appropriate strategy.

7. Borrowing Monies From Your Bank or Finance Company

The injection of additional borrowings into your business is a source of cash flow. Again, this should be looked at carefully and all other options of increasing cash flow considered before incurring additional debt and the associated responsibilities, usually including personal guarantees.

8. Incurring Leasing or Hire Purchase Finance

By acquiring machinery, furniture, etc. for your business using leasing or hire purchase finance, you are in fact introducing an outside source of money into your business – the finance company’s money. Again, you must review and consider the consequences of incurring outside debt usually with associated personal guarantees.

CONVERSELY CASH FLOW CAN BE REDUCED BY:

1. Incurring Trading Losses

The more losses you incur, the more cash flow can be expected to diminish.

2. Increasing Your Debtors’ Days Outstanding

If you collect your debtors slower, you cash flow will get worse and this will have ramifications on other aspects of your business. Eg. You may not be able to pay your suppliers and you may be put on a COD basis.

3. Increasing Your Stock Holding

If you increase the amount of stock you are holding without increasing your sales, then you have more money tied up in stock – you have applied more of your cash to stock – your cash flow is worse.

4. Paying Your Creditors’ Faster

If you pay your creditors faster, you will use your money faster – an effective decrease in cash flow. But this maybe offset by the gain of favourable trading terms or negotiated substantial discounts for prompt payment.

5. Drawing Monies From Your Business

This is withdrawing funds from your business for private or personal expenditure – an obvious decrease in the available cash.

6. Buying Buildings, Plant, Furniture

The purchase of fixed assets using the cash in the business. However, this may deny your business the opportunity to expand due to lack of working capital without additional borrowings being introduced at sometime in the future.

7. Repaying Your Bank, Finance Company Borrowings

The repayment of debt uses cash – it is an application of monies and can have a substantial impact on your cash flow. But the long-term benefits to the business are reduced interest expense and a healthier Balance Sheet.

8. Repaying Your Leasing, Hire Purchase Commitments

Again, by repaying leasing and hire purchase contract, you are using cash – but the business is stronger because of the reduced expenditure and the fact that a liability is diminishing or no longer exists.

Given the number of factors that affect cash flow, as seen in Small Business Co Pty Ltd, a combination of strategies can have a significant impact on a business’ cash position.

It is even possible to avoid incurring debt to acquire assets by employing strategies to increase cash flow.

So profit and cash flow – two very important aspects of any business – are two factors that do not necessarily go hand-in-hand.

But they are two areas over which you do have control if you implement policies to achieve optimum results.

And the results achieved are up to you…..

Where should you start?

Start with the largest balances and work down – there is some valuable information contained in your ledger that gets overlooked.

1. Unpaid invoices. If the number of requests for copy invoices and other queries that turn out not to be due. This could be a delaying tactic to enable them to make a payment on the due date but a reduced amount to hide a cash flow problem at their side. Of course this could also be down to adminsitrative inefficiencies.

2. Payment dates. Look at the last 12 months payment dates. If they pay more or less on the same day each month that would be described as low risk behavior (provided they are paying in full). If the payment date is getting later and later either they are checking out how far they can go without any consequences or they are finding it more difficult to get the money together each month – neither are good for you.

3. Closing balance on the account each month. Check and see if your exposure is getting higher or lower, obviously accounts that are rising need careful management but so does balances that are falling, does this mean that you are losing sales to competitors or is their business failing? Either way you should be concerned.

4. If you have regular customers who buy something every month, make a separate list of customers with an outstanding balance and no current sales. Have they gone somewhere else or have they closed down?

5. Check exposure to credit limit and review the ones that exceed the limit you have set. Has the account grown because your sales people are wonderful or because another supplier has put them on stop supply?

6. Last payment dates. Whether new balance or old, you should receive a payment from every live customer every month, even if they are paying on account. Sort your ledger in order of payment date starting with the oldest and up to the end of last month and ask yourself why. Finally, consider introducing a monitoring service with one of the information providers. They will notify you of any changes for your existing client base. As always if there is any area you would like to learn more about, we are available to help in any way we can.

Contributed by Declan Flood

• the right to claim interest for late payment;

• the right to claim reasonable debt recovery costs, unless the supplier has acted unreasonably;

• the right to challenge contractual terms that do not provide a substantial remedy against late payment;

• the right for “representative bodies” to challenge contractual terms that are grossly unfair on behalf of SMEs.

Guidance:

The first part of this section will address the right to interest and reasonable compensation for debt recovery costs. The second part will deal with contract terms.

Don’t I risk antagonising my customers if I use the legislation?

Using the legislation is your statutory right and is not designed to jeopardise existing customer relationships. Rather than seeking to encourage claims for interest and/or debt recovery compensation, the legislation’s primary aim is to deter companies from paying their bills late. By treating the legislation as an integral part of your payment terms, customers will become educated to the fact that this is part of the way that you like to do business.

It is worth knowing that, within the Republic of Ireland, you have six years which to make the claim for late payment interest and compensation. Even if you have stopped supplying the customer.

Part 1. Late payment interest and reasonable debt recovery costs

When can I claim either or both of them?

Claim(s) can be made once a payment is deemed late. Remember that if your contract makes provision for late payment interest, the statutory right to interest and the right to reasonable debt recovery costs will not apply. You may wish to contract for reasonable recovery costs to cover the event of late payment or if you are litigating you may be able to recover from the court some of the costs and disbursements incurred or some of your reasonably foreseeable losses flowing from the late payment.

When is a payment late?

Where there is an agreed credit period, and the supplier has agreed, either in writing or orally, a credit period with the purchaser, the payment is late if it is made after the last day of the credit period.

If no credit period has been agreed, then the Act sets a default period of 30 days after which interest can run. This default period does not constitute a statutory credit period. Where no credit period is agreed in a contract, the principal debt will still become due from the moment the goods are delivered or the service performed.

The 30-day default period starts running from the later of the actions:

• the delivery of the goods or the performance of the service by the supplier; or

• the day on which the purchaser has notice of the amount of the debt. A payment is late once the agreed credit period or the default period has expired.

What happens if the contract requires advance payment(s)?

There are several ways in which a contract can require payment(s) to be made before the goods are delivered or the service is performed. The Act does not give a right to interest unless at least some of the goods have been delivered or part of the service performed unless contractually agreed. If the parties wish to agree otherwise, they will need to make provision in the contract for a substantial remedy instead of statutory interest.

Some contracts stipulate that the whole contract price should be paid before the goods are delivered or the service is performed. If payment has not been made before the goods are delivered or the service is performed, then statutory interest starts to run from the day after the day on which all the goods are delivered or the whole service is performed.

Other contracts stipulate that payment should be made by instalments in relation to a delivery of any part of the goods or performance of any part of the service. Where payment of such an instalment is made late then statutory interest runs on the instalment from the day after the day on which the part of the goods are delivered or the part of the service is performed.

Finally, where an advance payment forms part of the contract price, but is not related to the delivery of some of the goods or performance of part of the service, then statutory interest runs from the day after the day on which all the goods are delivered or the whole service is performed.

What happens if there is no agreed credit period but the purchaser usually pays at the end of the month following the month in which the invoice is received?

Some purchasers and suppliers have a long-standing relationship in which this kind of payment arrangement has become standard practice. In these cases, the credit period is considered to end on the last day of the month following the month in which the invoice is received. Interest starts to run on the next day.

Where either:

• the purchaser is dealing with a new supplier; or

• there is any other reason to doubt whether this kind of arrangement can be regarded as established practice between the supplier and purchaser

• the purchaser should ensure that there is an agreed credit period – otherwise the default period of 30 days might apply.

Part 2. How do I make a claim for interest and/or reasonable debt recovery costs?

When the payment is late, a supplier should inform the purchaser that he or she is claiming interest on the late payment under the late payment legislation. It may be helpful to indicate the daily rate of interest that will be claimed, although it is not necessary to do so. The amount of compensation for debt recovery costs available is determined by the table below, which the supplier can refer to.

The compensation entitlement varies in accordance with the size of the debt:

• Debt Up to €999.99  -  €40.00

• €1,000.00 to €9,999.99  -  €70.00

• €10,000.00 or more  -  €100.00

For the purpose of claiming interest and/or compensation for debt recovery costs notification can be oral, but it is better to put it in writing, as this makes it easier to prove that notice has been given. It is necessary to provide all the information that should be carried on a standard invoice:

• how much is owed (it may be helpful to provide the total amount of interest owed at the date of the invoice for interest, and, if the principal has not been paid, the rate at which the interest will continue to accrue);

• the amount owed, and what it is owed for (stating which principal debt it relates to, quoting the original number of the invoice that requested payment of the principal debt);

• to whom payment should be made;

• by what date;

• to what address; and

• by what method the payment should be made (e.g. cheque, electronic transfer etc).

How should I inform purchasers that they will be charged interest and/or reasonable debt recovery costs if they pay late?

Rather than using it as a last resort when faced with an overdue invoice, the late payment legislation is designed to be a deterrent against late payment, and to be used as part of standard business practices and credit management techniques. In much the same way as a supplier reminds purchasers that payment is due within a specified time limit, the supplier should also remind them that interest and compensation for debt recovery costs will be charged on overdue invoices using the entitlements provided by the late payment legislation.

In addition to informing purchasers verbally of their right to charge interest and/or claim compensation for debt recovery costs as part of standard payment terms, suppliers should state clearly on all written communications, credit application forms, order confirmations, invoices and all contracts:

“We understand and will exercise our statutory right to claim interest and compensation for debt recovery costs under the late payment legislation if we are not paid according to agreed credit terms.”

Do I have to charge interest and/or debt recovery costs to all late payers?

No. It is not compulsory to use the late payment legislation. A supplier is free to decide whether or not to make a claim for interest or compensation for debt recovery costs.

How do I calculate how much late payment interest to charge?

Click on the image below to download a simple Excel spreadsheet to calculate the late payment interest you are legally entitled to levy on overdue invoices:

According to FLAC and IICM, there have been reports that some debt collectors in Ireland have used intimidatory and unscrupulous practices in the pursuit of debtors and, in their view, regulation would help get rid of the “cowboy” debt collectors and help establish an Irish debt collection code of conduct to deal with issues such as how often and what times in the day/evening collectors should call or visit debtors.

While we fully agree with the need to regulate and license the debt collection industry in Ireland, we would also argue that creditors and/or their agents should be allowed to exercise legitimate means to pursue unpaid monies from debtors. We therefore need to look closely at whether the Irish judicial system is currently up to the task. It seems obvious that if the legal system was less costly and more streamlined, particularly in the case of uncontested debt collection matters, creditors would be less likely to look to the so-called “cowboy” debt collectors to recover their debts.

Let’s not forget that, in many of the cases which are passed on to debt collectors, a creditor would have probably tried (and failed) many times to recover the debt using amicable means. Handing over the debt to a debt collection agency is very often a last resort. And, because a debtor possibly ignored peaceful efforts in the past to collect the debt, a creditor may be quite happy for a collection agency to employ more heavy-handed tactics. Any small business or individual that has been in the position where it has been owed money will fully understand the creditor’s position.

Yes we agree there ought to be regulation of debt collection services in Ireland, but let’s not forget that small and medium sized businesses are failing every day because of cashflow problems caused by debtors’ failure to pay legitimate bills. In Irish debt collection cases, as with most things in life, there are two sides to every story. It’s just a shame that, with organisations clamouring to uphold the rights of debtors, the rights and livelihoods of creditors are far too often being ignored.

Small Claims Court Ireland Online

Before you rush off to sue every Tom, Dick and Harry, take note that only the following types of claim are eligible:

• A claim in respect of goods or services bought for private use from someone selling them in the course of a business (consumer claim).

• A claim in respect of minor damage to property (but excluding personal injuries).

• A claim in respect of the non-return of a rent deposit in relation to a holiday premises (actions relating to rent deposits for places of residence must be brought to the Private Residential Tenancies Board.)

Get more information and advice about the Small Claims Court procedure in Ireland by downloading the following PDF guide:

A Guide to the Small Claims Court in Ireland