Why is cash different from profit?
Cash and profit are NOT the same thing
Understanding the difference between cash and profit can be hard for many business owners to get their heads’ around – but it’s important to know how they differ and why the difference matters.
Firstly, let’s take a look at some statistics...
Out of the 6 million or so limited companies currently registered in the UK, approximately half of them will no longer be trading in 5 years’ time. You might assume this will be due to a lack of profit, but actually, 4 out of 5 of them will stop trading because they’ve run out of cash – even though they may actually be turning a profit.
Therefore, it’s possible to trade at a loss and still keep your business going, as long as you’re able to fund the business from somewhere – for many SMEs, this means injecting their own money into the operation to stay afloat.
It’s all about the timing
One of the primary reasons that cash and profit are different is to do with timing e.g. when you declare profit and when you receive/pay cash out.
Cash availability is linked to working capital - how much money you need to sustain your business from day to day – which is how much money you’ve received from your customers, versus how much you’ve paid out to suppliers and other ongoing running costs (overheads).
The timing of declaring profit is triggered by invoice dates. Most businesses use credit terms, so from an accounting perspective, you declare the revenue and profit from the invoice date, but you may not receive the money for another 30 days, or whatever your terms are – and that is if you get paid on time!
Therefore, if your financial year runs from the 1st of January to the 31st of December, what you declare as revenue and profit is anything you’ve issued an invoice for during that period of time – but you may not actually have that cash in the bank yet.
This is where a cash flow statement comes in: it starts by showing the operating profit for the business and then reconciles this to show how much money has actually come in/out over the course of the year – and the chances are it’ll be different due to these timing differences.
You also have to take non-cash items into account when calculating profit i.e. your capital expenditure – the money you spend on fixed assets where the physical cash leaves your account straight away in one go, but you show and spread the cost over a number of years via depreciation.
You may also carry some unpaid invoices into the next financial year too – so while you showed the profit from the invoice date, some of these invoices will be carried into the next years as debtors. If people pay up faster than your terms dictate, from a cash perspective that gives you a boost, but it doesn’t affect your profit. This also works the other way around with your creditors – both can give a different picture in terms of profit versus cash.
Because there’s a difference between how much cash you’ve got and free cash flow (the cash your business actually has available to spend without restrictions) it’s important to understand these cash management nuances. Scenario planning can help you to identify whether or not your cash balance is actually as comfortable as it might look on paper, and whether it’s enough to cover future needs.
The matching or accruals principle
The final reason that cash and profit are different is due to the matching/accruals principle, where you match the revenue generated with what it costs to generate it.
This also might mean that you’ve incurred a cost in order to produce something to sell, but haven’t yet received the bill.
Because of these potentials, you may have shown a profit or loss without the cash having gone in or out.
This is why planning is so important – you need to keep close tabs on exactly where you are on paper, and in actual banked cash so you can get a true picture of your financial position.