Profits but No Cash: An Accounting Quirk
You’ve got your accounts back from your accountant. You see a profit - yippee!!!
However, you are left wondering, where is that money??
It says you have made a £20k profit - why is that not in your business bank account?
Two Accounting Methods
The key to this situation is first understanding the different accounting methods (I know that sounds very boring - but stick with me here).
Accounting methods refer to how the business reports its income 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 (i.e. based on the invoice date and not payment dates)
Showing profit without having cash occurs most often 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 for a client for a fee of £1,000. Under 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 and typically used for Companies Hosue and HMRC purposes. Since the revenues and the expenses of the business are matched up, it shows the true financial state of the company.
There is a situation where cash accounting is used, yet the profit is not reflected in the bank balance. This typically happens when the business is paying out a lot of money in debt repayments. That is because capital debt payments happen in the balance sheet and not in the profit and loss account.
Cash is not Profit
The accrual accounting method defines profit as the difference between the revenues earned and the expenses that 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 owed to the business are called accounts receivables. They are usually the top reason a company can have no cash on hand.
Receiving the Cash
Cash flow is essential to businesses. You will need money to pay for expenses like salaries and supplies. Making sure that the money matches the paper profits 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, incentivising early payments by giving discounts can encourage timely payments.
Another way to maintain cash for the business is focusing on expenses. Getting a line of credit can protect the cash flow while waiting for the cash payments to come in.
For other cash flow tips, you can download - Top Cashflow Strategies here