Profit vs Cashflow – I have no cash so why is my accountant saying I am profitable?

confusionCash flow is a common source of frustration that business owners have but it is a commonly misunderstood function of business. To understand why, you may have very little money in the bank when you appear to be profitable on paper, you need to understand the relationship between the profit and loss and the balance sheet.

What is profit?

By definition profit is the figure remaining from total sales once total expenses have been deducted. It can also be called the bottom line or net profit.

A Profit/loss statement is a periodic summary of how your net assets (Assets – Liabilities) were effected. For example if we make a profit of $500 our Net assets will increase by $500.

What is cash flow?

Cash flow is the movement of incoming and outgoing cash. Some expenses in the profit and loss report are non-cash items but they explain how an items balance or value has changed on the balance sheet. A typical example is depreciation. This explains that the asset has reduced in value but no cash has changed hands.

The purchase of an asset itself is a cash outgoing but it is recorded on the balance sheet. It does not directly affect the profit and loss. This type of transaction is known as an investing transaction.

Contrary to this is a loan and the loan repayments. The loan is a cash inflow and the repayments are a cash outgoing, but they are not recorded on the profit and loss at all, they are being recorded on the balance sheet. The loan is normally used to fund investing activities but can also fund expenses. The loan repayment is a record of cash being drained from the bank account and being used to reduce the loan account balance. Note that when interest on the loan is recorded the expense is interest and the loan balance increases on the balance sheet. The interest is not a cash movement and it is normally less than the cash repayment. These are known as a financing transaction.

Note cash flow effects both the profit and loss and the balance sheet.shutterstock_112139219

Many businesses can indeed generate healthy profit figures but can also fail as they ultimately run out of cash. You have heard the saying “Cash is King”? This is because Cash is the vital key in day to day operations, so it must be managed properly and conscientiously for the business to sustain itself long term.

Now when we consider a business’s cash flow we must consider all aspects and we must understand how various balance sheet items affect the cash flow and how profit and loss items may not have any impact at all. For example Debtors are an asset, however when they take their time to pay, our ability to meet our obligations is reduced. The reverse is also for Creditors, If we pay too quickly our cash resources are drained.

How to ensure you have good cash flow?

To ensure your business has enough cash to sustain its operations in the long term you need to work out a Cash Flow Budget. A cash flow budget is a tool to record the amount of money that you are realistically expecting to be coming in from your operations (sales of products or services) and what will drain the cash over a given time frame.

This budget helps predict the availability of cash in the business at any given time. It allows the business owner to plan whether he needs to borrow funds, inject capital or simply allow operations to sustain the business.

How to create a Cash Flow Budget

To be able to calculate a Cash Flow Budget you will need a best estimate of the sales performance of the business in a certain time frame. Realistic expectations in sales is vital to produce an accurate budget and you will need to gather the previous years’ income and expense reports.budget

Using something as simple as an excel spreadsheet that is easily adjusted, correlate the current results into similar months as they occurred the previous year. Take into account any changes you may already know that will be occurring in the future. You may want to increase sales production to facilitate more growth or you could be looking at employing a new staff member or planning to buy another piece of equipment and these will have an impact on the cash flow of the business so need to be accounted for in the cash flow budget.

Whether you have an existing business or a new business Presidential Accounting have been helping Gold Coast businesses with Cash Flow Budgets to help their business remain cash flow positive.
Contact us today if you would like to be in an up to date position regarding your cash flow rather than on the back foot.

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