Over the years I’ve seen quite a few clients that make the mistake of not separating their personal from their business finances. They’ll have one credit card and one bank account that they use for both. They’ll treat the money in this account as though it was their own because they own the business. It may sound obvious, but it’s really important to understand that your business is a separate entity from yourself and to mix the two is a very big mistake. Not only is it vital to keep business and personal income and expenses separate, but it’s also very important to understand the different types of money that exist within your business. Some of this money is yours and some of it belongs to the business.
There are basically four distinct but highly integrated categories of money that exist in your business: income, profit, flow and equity. A business can produce a profit but still be short of money or cash flow. Income and flow belong to the business while profit and equity belong to you. Income and profit are part of a business’s profit and loss while flow and equity are revealed through the cash flow statement and balance sheet. Let’s take a closer look at each of these.
The income belongs to the business. It’s the total of what you charge your clients, but if your business is turning over $500,000 a year it doesn’t mean you have that to spend. Income is found in the profit and loss statement and is often called the ‘top line’, ‘turnover’ or ‘what the business makes’. But what’s really important is not what you make but rather what you keep.
Once you’ve deducted the cost of sales and operating expenses from your income, what’s left is profit and this belongs to you and is what you get to keep, invest or spend after tax. Also known as ‘the bottom line’ it can be found, literally on the bottom line of the profit and loss statement. Profits are a great thing but most businesses fail due to poor or non-existent cash flow rather than a lack of profits.
This is what comes in and out of the business. Managing cash flow is critical in any business. It’s all about getting money into the business as soon as possible and not letting it go out until it absolutely needs to. There’s a big difference between money in a bank account in the balance sheet compared with aged debtors (or accounts receivable). Both are considered ‘income’ but only money in the bank has actually ‘flowed’ into the business. Your income statement is a snapshot in time, telling you how much and where the money in your business is coming from and going to, while cash flow is dynamic and tells you when you’re receiving and spending money.
Equity is yours to keep. It’s what you have left when you subtract liabilities from assets on the balance sheet and it represents the value of what you own and have to sell when that time comes. The two main things that will dictate if someone would want to buy your business are if it’s profitable now, and has been in the recent past, and if it doesn’t rely on you as the business owner.