Profitable, but no money?

Are you profitable at year end but have no ‘money’?

Reading time: 4 - 7 minutes

If that describes you, don’t worry, you’re not alone.

Whilst it’s not a new conversation that we as professional accountants and business advisors have with small business owners but, it remains a common one. 

In fact, Brian and Kurt previously recorded a short video called ‘Where’s my cash?’ and this article aims to build on that as it remains a really important subject. It also supplements our ‘Cash is King’ article, where we dug into how you can be profitable but, without cash, your business will struggle. 

So let's understand the mechanics of this timeless conundrum.

It’s quite normal that when a business owner reviews their financial statement, let's assume on a monthly basis for the purpose of this article, the eyes tend to focus on the bottom line of the income statement.

Assuming profit is good, then the gaze gradually moves to the amount of cash in the bank or the cash account amount showing on the balance sheet. This is where the questions usually start to bubble up. Given the assumed positive profit result it is natural to expect there to be a growing level of cash also. But often that is not the case. It is common that the amount of cash on hand is lower than expected.

Sound familiar?

The following question is logical, “How can I be making healthy profits but I don’t have much cash? 

As professional accountants and business advisors we can help you answer that question. And to be clear, where your cash has gone starts with us helping you review your balance sheet. Like most relationships in our lives, the one between cash flow and profit is one that needs to be understood and managed proactively. 

Cash Flow versus Profit

What is cash flow?

Cash flow is the money flowing in and out of a business. This is the lifeblood needed to fund daily operations such as wages, purchasing inventory, taxes and other operating costs. If cash on hand is negative then it demonstrates that the company has spent more cash that it has brought in during that same period. 

What is profit?

In simple terms profit is calculated as total revenue less total expenses. It helps to measure the ongoing sustainability of a company and provides a useful comparison against similar time periods of your competitors. 

But what’s the practical difference between the two?

Here’s a simplistic example to help answer that question.

  • Profit for a stated period = Revenue ($100,000 total sales) less expenses ($50,000) = positive $50,000 profit

  • Cash flow for the same stated period = Cash-in ($50,000 cash sales) less cash-out ($50,000 cash paid out) = $0 cash flow

So you can see how, whilst profitable in the stated period, cash flow was neutral. But how does this work? It’s essentially an accounting issue and can often be caused by paying for things with cash that don’t show up on the income statement. It can also be a difference in timing of when revenues and expenses are recognised in your accounting software, in relation to their collection and payment. 

Just to be clear, when we’re talking about cash in this context we don't mean the physical, folding type. We’re referring to the cash you have in your bank account i.e. you’re not using a line of credit or some other ‘borrowing’ device. 

It could be that your accountants prepared your financial statements using accrual basis accounting. This is where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.

Similarly, revenues are typically reported only when your product or service has been delivered to your customer. Once this milestone is met you have earned the right to receive the payment, regardless of when we you actually get paid by the client

So, if it's a cash flow issue, what can drive this?

When looking at your cash flow statement, there are three main areas to consider:

  1. Operations

  2. Investments

  3. Financing

Here a few examples of things for you to think about when analysing your cash flow statement...

Investing in Consumables

It could be your company has expended more cash than is expensed by your accounts because you're investing in consumable products. This is a classic example of Operations negatively impacting your cash flow.

And it could be that you have a really great reason for doing this. Maybe one of your vendors has a sale on an inventory item. You may take advantage of the sale and buy $10,000 of the item, but only sell $5,000 worth of the same during that reporting period. The net result would be a negative result of -$5,000 on your balance sheet and it wouldn’t yet show up on your income statement until you sell the items. 

Customer Credit

If you are offering extended payment terms you are essentially extending credit to your clients. That’s why they are often called ‘Credit Accounts’. In many industries this is ‘expected’ by clients but it comes at a cost...

The Invoice Market’s SME Cash Flow Crisis Report shows that Australian businesses are regularly owed an average $38,000 each. It’s not uncommon for larger companies to cite ‘lost in the system’ or ‘being reviewed’ as reasons for late payments. Unfortunately, all too often this is an inherent part of their system design so as to help maximise their own cash flow.

From an accounting perspective, when a credit account is used the income statement reflects that amount but the cash has not yet appeared in your account. Imagine how many client accounts this relates to in your business and it starts to become clear how the business could be showing a sizable profit before any cash has changed hands.

Investments

It’s really common for most small businesses to be investing in their growth. This could include long-term assets, equipment and other products, most of which usually require expenditure of cash. However, it’s common accounting practice to depreciate such investments over a longer period, certainly longer than the period of the cash outlay. Thus, another example of why there’s no cash left at the end of the year.

Loan Repayment

Many small businesses have some sort of borrowing facility or loan. Naturally, these need to be repaid and it's the cash account that typically reflects this. But accounting guidelines only permit the interest from each loan to be deducted. Thus, the principal payment lowers the cash account but doesn’t affect the reported profits. 

Prepaying Expenses

Not unlike taking advantage of a vendor's inventory item offer, many businesses choose to pre-pay rent or purchase insurance to secure a better deal. Of course, this means that more cash was consumed than product received during the same period. And from an accounting perspective, only a portion of the prepaid expense will be deducted from revenues during that reporting period. So cash flow suffers but your expenses don’t reflect the same hit.

So there’s a few areas for you to keep in mind when you’re wondering where your cash is, even though you may have made a healthy profit. As professional business advisors, we help our clients find their hidden cash. Inventory and accounts receivables are two hot areas that usually offer significant insights, but there are many more areas to consider. 

There is no doubt that cash (flow) is still king and being strategic about how to use your cash to pay down debt, make investments or secure future savings are subjects that we help our clients with. 

 

 

If you have any questions about your cash management. Contact us for professional business and accounting advise.