One of the biggest frustrations we often hear from business owners – is that they have made loads of profit – but have no idea where the cash is.
We often think that profit means cash in the bank, but it’s not that simple. In this article, we’ll dig deep into why your profit and loss account doesn’t always match your actual cash flow.
Understanding this difference can help you boost your profits, take home more money, and have more time for yourself.
What’s the Difference?
Let’s start by understanding the distinction between profit and cash flow. They’re not the same, and that’s where the confusion begins. It’s crucial to grasp this misconception and realise why it matters for your business’s success.
1: Tricky Assets and Non-Cash Expenses
Say you buy a car or stocks and shares – you would be creating assets in your balance sheet – you spend the cash now, or you take out a loan but this creates non-cash expenses like depreciation, amortisation to a future accounting period.
2: Accounts Payable and Receivable
Timing plays a sneaky role in profit and cash flow. You might make a sale now and raise an invoice to your customer which increases your profit – but they might pay later.
You might incur a cost now and get an invoice from a supplier which reduces profit – but you don’t pay it until later. Recognising revenue before actually receiving the cash or record expenses before paying them.
It can throw your profit and cash flow out of sync.
3: Prepaid Expenses and Revenue
When you pay for expenses upfront or receive money before providing goods or services, it affects your profit differently from your actual cash flow.
The cash would change hands now, but the income received in advance might need to be deferred to a future period and expense might need to be accrued to the current period.
4: The Accrual Accounting Mystery
Accrual accounting is what your fabulous accountant will be doing to create meaningful monthly, quarterly or annual accounts for you – it’s a way of matching income and expenses to the time they’re earned or incurred, regardless of when the cash comes in or goes out.
Understanding this accounting method helps unravel the profit-cash conundrum.
In simple terms your profit and loss should reflect income and expenses for your trading period – but your cash might be paid in advance, in arrears, in the same period or not at all!
5. Buying Stock and Cost of Sales
You might buy and pay for stock now creating an inventory asset in your balance sheet, but you would only write the cost back to your P&L when you sell it or write it off – creating another timing difference between profit and cash.
6. Loan Repayments
Say you take out a loan today, but pay it off over the next 5 years.
You would get the cash today which would increase your bank balance but not impact your profit. You spend it on one of the things above – say a company car, which increases your assets but does not reduce your profit.
Say you pay it off over 5 years – you will have a loan repayment to make each month reducing cash. Part of that loan repayment will be a capital reduction of the loan in your balance sheet – part will be an interest charge which reduces profit in your P&L.
7: Owners Pay and Director’s Loan Account
If you pay yourself a director’s salary – the cost will most likely match the cash drawn out or paid to HMRC – subject to a few weeks timing difference to pay HMRC next month BUT, if you are in the habit of taking cash out weekly or monthly in lieu of dividends declared at year end – you might be creating another timing difference between cash and profit.
We work around that issue by showing dividends drawn as non-operating expenses at the bottom of our management accounts so clients can see how much after tax, after dividend profit, they are adding to reserves each month.
So here we have some of the common reasons why cash does not always translate to profit. Once you get a better understanding of how these factors impact your own business, you can make smarter financial decisions and steer your business towards success.
Remember, profit matters, but cash flow is the lifeblood of your business. Start aligning your finances today to unlock your business’s full potential!
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