Any business can make profits but have no cash
The Sunday Nation
Nairobi,
26 August 2012
Two weeks ago, I wrote that a rental house on mortgage can make a profit yet the owner may not have cash to show for it. That conclusion puzzled Munyao George for several days and he finally admits that he doesn’t understand it. He writes, “How is it possible that I have a profit but no money? Does this only occur in the case of houses or is it possible in other businesses as well?”
Another reader, Josephine Wairimu, wondered how this can happen in a business where sales are made in cash and in advance. “I thought this is only possible if a business sells goods on credit. Please explain some more.”
Munyao and Josephine would be interested to know that last year, one of the companies listed at the Nairobi Securities Exchange suffered a severe bout of this cashless profit. It made a very good income in 2010 and the directors went ahead to declare dividends for shareholders. But unfortunately, come payment day, the company did not have the cash needed so it had to take a bank loan to meet the obligation!
To understand how this can happen, suppose you start a business where you are buying a certain product at Sh200 and selling it at Sh250 thereby making a gross profit of Sh50 per piece. Let’s say that you are able to sell 1,000 pieces each month, thus you monthly gross income is Sh50,000.
From this you pay your overheads of sh20,000 (rent, salaries, utilities etc) and you are left with Sh30,000 net – before tax, of course. Let us further assume that this is a side-hustle and you have decided not to touch the profits for a whole year. You operate like this from January to November but come December, you suspect that the Christmas booms can easily double your sales.
Thus instead of buying the usual 1,000 pieces, you buy 2,600. You also hire an extra temporary shop attendant at Sh10,000 to help in selling.
The purchase cost of 2,600 pieces at Sh200 each is Sh520,000. Adding your normal working capital (Sh200,000) to the saved profits over 11 months (Sh330,000) gives Sh530,000 – more than enough to buy the 2,600 pieces.
But because of the size of your order, your consignment arrives late and you miss the Christmas boom season. You don’t even get your usual 1,000 pieces. So you have nothing to sell in December!
Thank God: you hade spared Sh10,000 from your savings. You have at least enough to pay extra temporary employee but not enough for the other overheads. You must dig into your pocket for the remaining Sh20,000 (or borrow from the bank); otherwise, your landlord might evict you!
Does that mean that your business made a loss (the Sh20,000 added) during that year? Of course not! You have made some profit, only that it is not available in cash form. It is tied up in the 2,600 pieces of stock that you ordered. The profit is Sh300,000: that is, the Sh330,000 made up to November, minus the Sh30,000 expenses for December.
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