I’ve often heard entrepreneurs tell me that they are profitable in one breath, then tell me they aren’t paying themselves yet in the next breath.
These are usually contradictory statements.
Bootstrappers Often Don’t Pay Themselves
In the early days of a new company it’s pretty standard that founders don’t draw a salary. Or if they do pay themselves, it’s just a fraction of what their time and effort is worth.
Zero founder pay is a classic bootstrapping technique. Very low founder pay often follows, when cash flow improves from negative to positive (before founder pay).
And even when founders are able to pay themselves a “normal” salary (whatever that means), there can be times when the inward flow of cash suddenly slows, and founders once again stop or dramatically decrease their pay temporarily.
This is normal for young companies.
Can You Be Profitable Without Paying Yourself?
But what often happens as unpaid “sweat equity” labor pours into the business is that the founders start to see this as normal. And when there is cash left over at the end of the month, it feels like the business is profitable.
It’s certainly much better than negative cash flow every month so that founders are paying for the privilege of working at their startup. I know that feeling oh so well.
But it’s not the same as being profitable.
Profit Versus Positive Cash Flow
As a reminder, profit is an accounting term that may or may not correspond to more cash coming in versus going out.
Accountants who measure profit according to Generally Accepted Accounting Principles or GAAP have to follow a bunch of rules in order to match revenue with the expenses accrued over time necessary to generate that revenue.
There are plenty of GAAP rules that will show up in your accounting software and taxes that can indicate you’re profitable while your cash balance is going down. For example:
- Unsold inventory going up to take advantage of bulk discounts will make you more profitable but decrease cash flow
- Purchasing equipment that is useful for many years will have a modest negative impact on profitability short term but a big negative impact on short term cash flow
- A big contract can jack up profitability in one month while cash goes down because the big customer hasn’t paid their bill yet.
This is why it’s good to know the difference between being profitable, and being cash flow positive. It’s possible to go out of business when you’re profitable if you’re not paying attention to being cash flow negative.
Happiness is positive cash flow.
Your Goal: Sustainable Profitability and Positive Operating Cash Flow
Don’t get me wrong: profitability is a good thing.
In the long term your goal should be to run a business that is both profitable, from an accounting standpoint, and generating positive operating cash flow.
So what’s the important difference of “operating” cash flow?
In the kind of cash flow statements I like to see when I’m trying to understand a business, there are three different categories of activities that generate cash flow, both in and out:
- Operating activities
- Investing activities
- Financing activities
Operating activities that impact cash flow are predominantly:
- Are you profitable from an accounting point of view, adjusted for depreciation and amortization?
- Are your customer collectables (accounts receivable) going up or down?
- Are your supplier bills (accounts payable) going up or down?
- Is your inventory going up or down?
When the sum of these activities is positive on a sustained basis, you have arrived!
But to be sustainable, your pay needs to be accounted for. How do you figure that out if you’re not yet paying yourself? Ask this question: If you needed to replace yourself for three months, how much would you need to pay somebody else to do what you do?
Add that amount to your expenses – in your head, not in your accounting software – in order to figure out if you are profitable or not.
There are also two other categories of cash flow activities.
So-called Investing Activities are those dealing with long-term assets. Are you buying or selling equipment, real estate, land, or creating intellectual property that will be (or has been) valuable for years to the business? Those long term investments can have a big impact on cash short term.
Finally, there can be Financing Activities that either generate cash or use cash:
- Are you receiving or paying down a loan?
- Are you receiving equity?
- Are you paying dividends to equity holders?
It’s important to break out these different sources of cash flow so that you as a business owner can clearly see how you’re doing. As your business grows and becomes more complicated it’s easy to get confused.
And because building a company is so hard, and we entrepreneurs like to be optimists, we like to tell ourselves encouraging stories.
Like, “we’re profitable” even when we aren’t paying ourselves yet.
A New Name For Positive Cash Without Pay?
If you’re telling yourself this story, don’t be discouraged. It’s better than cash going out every month, and for some young businesses it really is a notable marker on the path to positive cash flow.
You can’t say you’re profitable, but maybe we need a new term to describe this milestone. It ought to sound great but not be confused with profitability. How about:
- Bootstrap positive
- Positive CBFP (Cash Before Founder Pay)
- Positive EBAP (Earnings Before Accrued Payroll)
- Positive CFBSE (Cash Flow Before Sweat Equity)
What do you think? Do you have a better name for it?