Have you ever had the unexpected experience of meeting with your accountant and being informed that your business is showing profit while you have no funds to show for it? Most likely in the same meeting, you were probably informed of the amount of income tax that is due and payable. Leaving the meeting baffled as you know the business bank account is running in overdraft.
Understanding business profit and cash flow nuances is essential for the health of your business. This blog post will delve into the differences between these concepts. We will unpack the importance of understanding and actively tracking both these indicators.
Defining Business Profit:
Profit refers to the surplus remaining after deducting your business expenses from your revenue. Simply put it is Revenue or Sales minus all expenses equals either a profit (if surplus) or a loss.
This measurement provides a snapshot of your company’s financial performance over a specific period, usually calculated on a monthly, quarterly, or annual basis. Profit serves as a vital indicator of success, reflecting the effectiveness of revenue generation and cost management strategies.
Understanding Cash Flow:
Cash flow represents the movement of money in and out of your business during a particular period. It includes both operational and non-operational cash inflows and outflows, including revenue, expenses, investments, and loan repayments. Cash flow focuses on actual cash transactions, offering a real-time liquidity assessment and financial flexibility.
Why is there a difference between Profit and Cash Flow?
While profit and cash flow interconnect, they fulfil distinct purposes and exhibit fundamental differences:
1. Timing
Profit is recorded when revenue is earned and expenses are incurred, irrespective of when the actual payment is received or made. This is the accrual basis and is used for accounting and tax purposes. Revenue is recorded on the date of the sale, while the payment terms may be 30 days, meaning that the cash from that revenue transaction will only be banked in the following month.
Cash flow reflects the timing of the actual inflow and outflow of cash when receiving or effecting payments. Practically this means that you will record profit in Month 1, but only receive the cash in Month 2.
2. Non-cash items
Profit may include non-cash items such as depreciation, provisions, and special rules on timing for recognising service revenue, which impact the bottom line but do not affect cash flow. Conversely, cash flow accounts for all cash transactions, and ignores non-cash items such as depreciation and provisions.
3. Capital payments
When purchasing capital items i.e. items with a life span of longer than one year for example a delivery vehicle, the payment is considered capital in nature and would not be included in the calculation of the business profit. Instead, the vehicle is depreciated over its lifespan and only the depreciation would be included in the profit i.e. ten years. This capital payment will have a huge impact on your cash flow though, as you will record the full value of the payment on the date that the payment is made.
Why do you need to know this?
Understanding the difference between profit and cash flow is indispensable for effective financial management and decision-making. While profit indicates overall profitability, positive cash flow is essential for maintaining liquidity and ensuring your business’s continuity, especially during periods of economic uncertainty or unforeseen expenses.
Proper cash flow planning will ensure that your business can perform on current obligations, service current and new orders, and keep tax compliant without giving you sleepless nights.
Tips for managing profits and cash flow:
1. Monitor cash flow regularly
Maintain a close eye on cash flow statements to track incoming and outgoing cash flows, identify trends, and anticipate potential cash shortages or surpluses. You must be aware of regulatory payments and their due dates i.e. tax, COID, PAYE etc.
Also, ensure that you plan for the replacement of capital items as these could have a major impact on your cash flow.
2. Budget wisely
Develop comprehensive budgets that align with your business goals and revenue projections. Factor in both profits and cash flow considerations to ensure financial stability and avoid a cash flow crisis by creating a separate cash flow statement in line with your comprehensive budget.
If you are new to budgeting, try starting with your known expenses and their timing. Work your way up to determine a baseline revenue target. Also remember, that VAT should be excluded from your budget, but included in your cash flow projections.
3. Minimise accounts receivable
Accelerate cash inflows by implementing efficient accounts receivable management practices, such as offering discounts for early payments and promptly following up on overdue invoices.
Make sure that your receivable payment terms align with your payables payment terms. If your debtors are paying on 60 days and you are paying your suppliers on 30 days, you could be moving into a negative cash flow position.
4. Maximise accounts payable and control expenses
Exercise prudence when managing expenses, keeping a close eye on variable and discretionary costs. Implement cost-saving measures where possible without compromising quality or operational efficiency.
Good supplier relations are essential so it is important to balance payment terms with the relationship with your creditor.
5. Build cash reserves
Establish an emergency fund or cash reserve to buffer against unforeseen expenses or temporary revenue fluctuations. Aim to maintain an adequate cushion to cover several months’ worth of operating expenses.
6. Finance strategy
When looking at finance options, ensure that the type of finance matches the lifespan of the asset i.e. a mortgage bond could be a good fit for financing solar energy for your production plant, while debtor factoring would be appropriate to finance short periods of working capital shortages.
If you are in the retail industry, Merchant Capital has some great options. Please feel free to get in touch for more information
While profit and cash flow are interconnected elements of a business’s financial landscape, they serve distinct purposes and require careful management. By understanding the differences between profits and cash flow and implementing sound financial practices, you can navigate the complexities of entrepreneurship with confidence, ensuring long-term success and resilience in an ever-evolving marketplace.
If you enjoyed this blog post then make sure to check out our previous post: 8 Avoidable Financial Mistakes that Business Owners make
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