It starts with the accounting method
Setting up a business can be tricky. Despite good intentions, it is easier to fail than it is to succeed. For those who manage to do well, a positive profit and loss statement is nothing less than victory. But there are times when this victory does not seem to bring in the spoils. How can a business be profitable but have no cash?
Two Accounting Methods
The key to this situation is first understanding the different accounting methods. Accounting methods refer to how the business reports its revenues and expenses. There are two different types: cash and accrual. Cash accounting reports the revenues and expenses when the business receives them while accrual accounting reports them when the sale is made, or the expense incurred.
Showing profit without having cash occurs when the accrual accounting method is used. This is because income is recorded when the charge for the service is sent out instead of when the money is received.
For example, you design a logo of a client for a fee of £1,000. In accrual accounting, the £1,000 is recorded as a sale when the invoice is sent out. You do not have the money in the bank yet, but your profit and loss statement already reflects it.
Cash accounting is more straightforward, but accrual accounting is more descriptive of the state of the business. Since the revenues and the expenses of the business are matched up, it shows the true financial state of the company.
Cash is not Profit
The accrual accounting method defines profit as the difference between the revenues earned and the expenses occurred. It is important to note that the revenue will not refer to the money it already received. This means that on paper, money has already come in the business but does not necessarily mean cash on hand.
To illustrate, let us take the example of designing a logo in exchange for £1,000. Payment is expected 30 days after the invoice is sent out. A sale of £1,000 is recorded in the books because accrual accounting is used. During that time, an expense — £800 for materials – is incurred.
Accrual accounting would reflect a profit of £200, which is £1,000 is revenue minus £800 of expense. However, since the money has not yet been received, cash has decreased by £800. Hence, there is a profit for the business but no cash.
These sales or assets that are owed to the business are called accounts receivables. They are usually the top reason why a business can have no cash on hand.
Receiving the Cash
Cash flow is important to businesses. You will need money to pay for expenses like salaries and supplies. Making sure that the profits on paper are matched by the money in the bank account indicates a healthy operation.
One way to ensure that a business does not come up short on cash is to collect the accounts receivables or the money owed to the business. For example, incentivizing early payments by giving discounts can encourage timely payments.
Another way to maintain cash for the business is by focusing on the expenses. Getting a line of credit can protect the cash flow while waiting for the cash payments to come in.