"Profit" is a simple idea: revenue minus expenses. What you make, minus what you owe, is what you end up with.
And you would think that making a profit is the goal of each and every small business owner out there--but the reality is actually a bit more complicated than that.
As it turns out, your business's profitability has a direct impact on your eligibility for business financing--it's proof that your business has enough liquid capital to pay back a loan, which is naturally what lenders want to see.
So why are many small business owners not showing profitability, and what can they do to still qualify for a small business loan?
Profitability vs. Cash Flow Positive
The first step to answering those questions is understanding the difference between being profitable and being cash flow positive--at least, in the eyes of a potential lender.
If your small business is cash flow positive, that means you have more cash flowing into your business than you have flowing out over the same period of time.
You might think this translates into profitability, but that's not exactly the case. Why not?
It all has to do with a single financial document:
Your tax returns.
Although other documents, like a Profit & Loss Statement, can show whether your business is profitable or not, your lenders will care mostly about your tax returns when they're looking for profitability.
Your tax returns are the be-all end-all of financial documents and are what many lenders base their underwriting off of, for one simple reason: they're what you show the government, so they're seen as more legitimate.
Basically, your cash flow depends on whether your cash is going in or out over a set period of time, while your profitability (for business lenders) depends on what your tax returns show.
Why is this important?
Cash Flow Positive, Profitability Negative
Plenty of small business owners are in the interesting position of being cash flow positive but not showing profitability on their tax returns.
Simple: even if you have positive cash flow, your tax returns could still show a net loss because of officer compensation, interest expenses, depreciation costs, and more. These lower your income but don't require cash payments, so your tax returns show a loss--without affecting your cash flow. The benefit? A loss will reduce the business's income--and its income taxes.
But as we said before, profitability is an important factor of your small business loan eligibility. It shows that your business has enough extra money to pay back what you borrow--which all lenders want to see.
Fixing the Profitability Problem
One way to solve this problem?
Work towards showing a profit instead of a loss on your tax returns, especially if you know that you'll need business financing soon.
But there are a few other things to consider:
1. Lenders & Add Backs
Some lenders will add back things on your tax returns--like the officer compensation, depreciation, and interest expenses I mentioned before--to see whether you're "truly" profitable underneath what you claim on your tax returns.
It's important to note that this is only the policy for some lenders, not all. Make sure to be aware of each lender's add back policy before applying or pursuing funding through them so you don't waste time.
2. Your Type of Loan Matters
The kind of financing you're looking for is an important factor, too. Especially in the alternative lending industry, there are lots of lenders with all sorts of different loan structures--and some care about profitability a lot, while others don't at all.
Lenders who deal with short-term loans, asset-based loans (like equipment financing or invoice financing), or business credit cards don't look for profitability on your tax returns. They're more interested in your personal credit score, and to a lesser degree, your annual revenue and time in business.
Meanwhile, lenders of traditional term loans and SBA loans care a lot more about your business's profitability. In fact, this could make or break your loan application--so know whether your tax returns show a profit or not before applying.
What kind of financing you're applying for and which lenders you'd work with will impact how you'll need to approach profitability on your tax returns. Figure those out and, depending on your business's needs, you might not have to change a thing.