How a business can make profit but have no cash to pay debts

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

10 February 2019

Last week, I mentioned in closing that “…cash is king. A profitable business without cash will close down but a loss-maker awash with cash will continue operating.” This remark has disturbed a number of readers and they have asked whether it is realistic to expect a profit-making business to have a shortage of cash.

Well, the answer is not only yes, but also that this is a very common state of affairs. Indeed, quite often when a business fails, we hear the senior managers talking about “cash flow challenges”: the never say that they are making losses…

The most common example of this situation is when people buy houses on loan and then rent them out. If you borrow Sh5 million at 15 per cent for 15 years, your monthly installment will be just under Sh70,000.

If you buy a house for this much and let it out, you will not be able to charge Sh70,000 in rent. The best you can get is about Sh30,000. So, from the start, you have a cash shortfall of Sh40,000 which you must raise from other resources.

Now, part of the Sh70,000 instalment is interest on the loan and it is very high at the beginning. However, it gradually reduces with time and by the middle of the tenth year, it will be less than Sh30,000.

From that point onwards, your house becomes profitable – assuming you don’t increase the rent. Unfortunately, you still have to pay Sh70,000 to the bank so you have a profitable enterprise that is not generating enough cash to sustain itself!

Normal businesses can also face a similar predicament. Suppose you have a small shop where you sell just one product. Say your rent and other fixed expenses are Sh10,000 per month.

Further; suppose that you buy the stock at Sh80 and sell it at Sh100. This makes you a gross margin of Sh20 per item. If you sell 2,000 pieces monthly, your total gross margin is Sh20 x 2,000 = Sh40,000. After paying out your expenses, you are left with Sh30,000 profit. So far, so good.

Suppose your supplier offers you a deal to buy 10,000 pieces and get 10 per cent discount; plus, three months credit payable in equal monthly installments. If you take the it, you will owe the supplier Sh720,000 (Sh72 x 10,000 pieces) and pay Sh240,000 each month.

But; you still sell 2,000 pieces per month. You are now making more profit because of the discount: At Sh28 per piece, your gross margin is Sh56,000. This leaves you with Sh46,000 after expenses. Great! Or is it?

Selling 2,000 pieces generates Sh200,000. Yet you need to pay out Sh240,000 + Sh10,000 = Sh250,000. That is, you have a cash shortfall of Sh50,000 every month; even though you are making Sh46,000, you still won’t be able to meet your financial obligations.

So, you find yourself having to negotiate a repayment extension with your supplier…four months, then five, then six…before too long your supplier gets tired of waiting and calls in the money. You close the shop citing “cash flow challenges”.