I was reviewing a clients’ annual performance recently. It was their first full year in business, and when hearing their after tax (and dividend) profit for the year, the client asked a simple yet pertinent question; why isn’t that profit sat in my bank account?
The short answer is that profit doesn’t equal cash, given that cash flow is constantly moving and changes day by day. However, I jotted down a few reasons for this from analysing their accounts which are common place for all business. So here’s a few reasons why your profit may not equal the cash in your bank:
You haven’t been paid everything from your clients for the period
Accountants use the accruals concept when preparing accounts. This means that revenue is accounted for in the period where it is earned rather than paid. So let’s say that your company year end is 31st December 2019. You invoice a client on 30th December 2019 for work that’s been completed. This revenue therefore is correctly accounted for in your 31st December 2019 accounts.
However, you haven’t received payment by 31st December 2019, and therefore the cash isn’t in your bank account. You’re therefore showing revenue (and profit) before getting the cash in your bank.
You’ve prepaid costs
Likewise, under the accruals concept, costs are declared in your Profit & Loss account as and when they occur. If you pay for a cost before receiving it, the cost will be declared at a later date despite the cash having already left your bank account.
A common example of this is a marketing event. Let’s say on 1st December 2019 you pay to attend an event in August 2020. The cash leaves your bank in the December 2019 year, but isn’t declared as a cost until the December 2020 year when the event happens. So you’re showing the cash leaving your bank account before the cost is declared.
You have Work In Progress
Another common example for a service business. You reach the end of your accounting year at 31st December 2019. You have a £10k project that you’re 50% of the way through, however you’ve agreed with the client to bill everything at the end of the project. So you’ve ‘earned’ £5k of revenue that you’ve not yet billed or received the cash for.
Accounting principles mean that you’d declare the £5k revenue in the December 2019 year, despite not having invoiced the client yet or received the cash. So as with being owed money from clients you’re declaring the revenue before receiving the cash.
You’ve invested in Fixed Assets
During the year you may have invested in Equipment which will more than likely last for more than 1 year. Common examples of this would be laptops, electronic equipment and office equipment such as chairs and desks. These are classed as business ‘assets’ and sit on your company Balance Sheet rather than being written off as costs in the Profit & Loss account. So you’ve invested your profit (and cash) in assets.
It’s important to understand that due to the above reasons (and a few more), your cash balance will never equal the profits you’ve made. However, by constantly improving your billing processes, credit control and cost control you can aim to continuously improve your cash balance in line with the increase in profits made by your business. If you’d like some ideas on how to do this drop me an email at martyn@agencycfo.co.uk or call on 07866200275.
