I had a contractor client once, who built relatively low-end homes, and whose revenue had dropped from $300 million a year, to $60 million. Despite the substantial drop in revenue, he still appeared to be profitable even at $60 million.
When we started to discuss his financial condition, he had about $1.5 million of cash on hand, and about $7.5 million in customer deposits. Even though he showed he was profitable in his income statement, none of the cash he had was actually his; it was his customer’s!
In my client’s eyes, once a customer gave him a deposit, it was his money. I explained to him that the true definition of a deposit is “It ain’t your money!” (I told him in my own words)
Think about it this way: When you activate a new utility service on your property, and the provider requires a deposit from you, do those funds become income? No! It’s protection money in case you decide to not pay your bill! Deposits mean security, and they are designed to protect not only the contractor/business owner, but also the customers.
In the case of this contractor, customers are giving him a security deposit to build them a home, with the expectation that if he reneges on the agreement, they can get their money back. It’s going to be damned hard to give them a deposit back if he’s spent their money elsewhere!
It happens way too often; business owners live off their line of credit, and set themselves on a course for disaster! From an accrual basis, the contractor was showing profit on 60 million, but from a cash-basis, he’s living on “Other People’s Money” (OPM).The client had done ok for themselves over the years, but as their revenue and profits shrunk by 60% to 70%, they found themselves living off OPM. Way too often I see owners who are far into their lines of credit, and have become agitated with us when confronted about it. It’s not their money!
The only thing that matters when determining the success of your business is cash, cash, cash, more cash, and when you think you’ve got enough, more cash. I challenge you to shut down your line of credit, and don’t use it for 90 days. See how well you do. If you are cash-stressed, then it really boils down to bad management, no real profits and nothing else.
The last time I checked, the expenses of a business, whether they be payroll, bank loans, vendor payables, taxes, or health insurance, are all paid for with cash. The concept of accrual from a matching principle perspective makes perfect sense to anyone with an accounting background, but if your cash flow is not improving, building up reserves, and you are relying heavily on a line of credit or deposits to keep operating, then you are in for a rude awakening. You are not really profitable!
Anyone can make an accrual financial statement look good, but the true measurement of success is cash. Cash profit, cash in the bank. Report on an accrual basis – live and breathe on a cash basis!