Profit tells you where you are going, but businesses fail because they run out of money. It is entirely possible for a business to fail despite never showing a loss.
When you get down to it, businesses are forced to close because they can't pay their bills. Now posting a loss generally isn't going to help your cashflow in the long term, so let's try to keep that bottom line up. But there are other ways to run into trouble too.
To get a better grip on this, let's divide businesses into two broad categories - cashflow positive and cashflow negative. In a cashflow positive business you tend to get paid before you have to pay out the expenses. In a cashflow negative business, you tend to have to pay your expenses before you get paid by your clients.
The easiest way to calculate which side of the line you are on is to relate the size of your debtors and creditors ledgers in relation to your turnover and expenses.
If your monthly turnover is R100 000.00 per month and your debtors ledger is at R200 000.00, you are being paid (on average) at 60 days.
If your monthly expenses are R90 000.00 per month and your creditors ledger is at R90 000.00, you are paying (on average) at 30 days. This would be a cashflow negative business. The business is financing that gap of R110 000.00 out of working capital. Either from owner capital or by overdraft. The profit margin is 10%.
To clearly illustrate the problem here, imagine for a moment that the business doubles in a year.
Turnover goes to R200 000 per month, debtors to R400 000.00, expenses to R180 000 per month, creditors to R180 000. The business is financing the gap of R220 000 - an increase of R110 000.00 for working capital.
Let's look at what has happened to profit. It's moved from R10 000.00 per month to R20 000.00 per month - on average an increase of R5 000 per month or R60 000.00 for the year.
But that extra R60 000.00 profit has cost you R110 000 in capital. And let's assume that we're talking after tax profit and there have been no other capital demands on your growth.
Where are you going to find that extra R50 000.00?