I know what you’re thinking! Seth have you lost your mind?! How can a profitable business possibly go under?
Rental Real Estate is a great example of how we can operate profitably and still go out of business. Why? Cash flow that’s why! Confused? Seems like if the profits are there and collections aren’t an issue then the cash flow should be there to support the operations of a business right? This is where it becomes really important as a business owner to understand your financial statements – even if you’re not an accountant. Your financial statements give you information about your business that can literally make the difference between staying in business and going under.
This applies to every business
Rental Real Estate is just one example. The point here is that no matter what business you’re in you must understand these concepts so that you can read your financial statements properly and evaluate your business’ ability to continue as a going concern. Many times in a business we have substantial cash outflows that do not impact the profit and loss. If our income is not sufficient to sustain this, then the business goes under EVEN WITH A PROFIT on the books!
What does this look like?
Think about the Rental Real Estate Example. Often times you have a large loan on the books. That loan payoff will consist mostly of interest in the beginning. No problem there because that is an expense so it is reflected in the Profit and Loss. The other part of that same loan payment is the principal payoff. This is not reflected in the profit and loss. It is a portion of your total cash out flow that is reflected on the balance sheet. This means that you can be profitable, but if the principal you are paying down on the loan is more than your profits then your cash flow is negative and that is exactly how a profitable business can go out of business. I am going to show you a simple example here but keep in mind that in many real businesses these numbers would be multiplied many times over.
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