Understand Profit, Cash Flow and ROI to Ensure Your Business' Financial Health Remember: You can't buy beer with profit; you can only buy beer with cash.

By Doug and Polly White

Opinions expressed by Entrepreneur contributors are their own.

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Recently, we helped a large mechanical contractor turn around its business. And we were successful in taking the company from loss to profit. However, the problem wasn't solved because, before we arrived, the owners had taken out several business and personal loans to keep the company afloat.

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As a result, shortly after it started making a profit, the company hit a cash-flow crisis. At first, the owners, couldn't understand why, if they were making money, they had a problem with cash. Further, they wanted to know why they weren't paying down the principle on the loans they had accumulated. Simply put, they wanted to know why they weren't making money?

The answer lies in understanding the differences among profit, cash flow and return on investment (ROI). We explained to the owners that their accountant was correct; the company was profitable. The number on the bottom of their income statement was positive. In short: If the revenue you realize each month exceeds the expenses that generated that revenue, you are profitable.

And, this is good. However, it does not necessarily mean that you have positive cash flow.

A business may be very profitable, but if its inventory, accounts receivable and/or fixed assets are growing rapidly, it may not have a positive cash flow. Growing these three accounts requires cash. In the case of our mechanical contractor, the company was growing for the first time in years. The owners were spending cash to buy inventory, among other things. However, these are all balance-sheet accounts that do not immediately affect the income statement. Therefore, they have no impact on profitability.

It is absolutely possible for a business to be profitable and hemorrhaging cash at the same time. Our contractor in fact didn't have cash -- one of the reasons it wasn't able to pay down the balances on its loans. That's why we moved to stem the problem by instituting collection procedures and other processes that helped the contractor manage its crisis, come through this short-term struggle and avoid a future disaster.

If you find that your company is in a similar situation, ask your accountant to analyze your monthly cash flow over the past couple of years. It is possible that your cash is being spent to grow assets. If this isn't the case, we suggest that you have an independent third party do a thorough check for embezzlement.

We've seen thieves pull amazing stunts to make the books look right on the surface even as they siphon cash out of the business.

Related: 5 Ways To Boost Your Business' Cash Flow

It is also possible to have a profitable business, and even a positive cash flow, but not have a good ROI. While our contractor's actual number was much larger, let's say the owners initially funded the enterprise with a $150,000 investment. Let's also assume that they hadn't put any further cash into the business.

Now, let's assume that their annual profit was $1,500 and that this was also the cash flow. ROI is calculated as: profit divided by investment. So, in our company's case, the ROI would be 1 percent -- hardly an impressive performance. At this rate, it would take 100 years to earn back the original investment. Depending on the specifics of your own business situation, we suggest that you target at least a 10 percent to 20 percent return on investment.

To return to our client's initial question, they are now making money. The business is profitable. The next question is, how profitable? This is often measured by return on sales (ROS) which is calculated as profit divided by sales. The appropriate ROS target is a function of the specific situation, but for many businesses, a 10 percent ROS is a good target (obviously, more is better).

It is important to understand profitability and to make sure that this translates into an acceptable positive cash flow. As a finance expert told us, "You can't buy beer with profit; you can only buy beer with cash." Finally, make sure that your ROI is acceptable. If you are achieving your target ROS, but still not getting the ROI you need, the reason is likely that you need to grow your sales without making an additional investment. In other words, you need to improve your asset utilization (sometimes expressed as "sales divided by assets").

Assessing the financial health of your business is not a one-dimensional exercise. However, if your ROS is acceptable, your profit is translating into cash flow and you have a good ROI, you can rest assured that the financial health of your business is good.

Related: 3 Ways to Track the True Value, Not Just Return on Investment, of Your Content Marketing

By the way, our client is on track to be completely debt free in four years. Given the amount of debt he began with, this is a spectacular achievement.

Doug and Polly White

Entrepreneurs, Small Business Experts, Consultants, Speakers

Doug and Polly White are small business experts, speakers and consultants who work with entrepreneurs through Whitestone Partners. They are also co-authors of the book Let Go to GROW, which focuses on growing your business.

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