What is the difference between profit and cash?
Author: Russell SmithJuly 1, 2015
The business owner wants to grow the business so starts investing in marketing. The suppliers that this business owner is using have 30 day terms i.e. they want to be paid within 30 days. The marketing is successful and the sales roll in to the business. Turnover is up and the business owner is pleased.
Despite the heavy spend on marketing, the business owner is smart and is tracking the profit. Fortunately, the business is clearly making a profit and everybody is pleased.
However, the business owner has made two miscalculations. Firstly, they have focussed entirely on profit and ignored cash and secondly, because of this, they have given their customers 60 days terms ie given the customer 60 days to pay the sales invoices. So right from the start of the business there will be a cash hole i.e. the business is paying their suppliers in 30 days and receiving the cash in 60 days.
This isn’t the end of the world if the business owner had invested some cash in the business at the start, what accountants would call ‘working capital. But they haven’t and then they are faced with the confusing situation of patting themselves on the back for all the profit they made and then realising they can’t pay their suppliers.
Faced with angry calls from suppliers and then even scarier calls and letters from HM Revenue & Customers the business owner does two things to try and rectify the situation. Firstly, they review their credit control procedures and start tightening up on the systems to ensure the customers are paying them on time and secondly, they boost the marketing spend to increase the sales to trade more and therefore make more profit.
Both are misjudgements which will lead to a financial catastrophe. Firstly, whilst it is good for the credit control procedures to be improved, the customers are still paying on 60 days which is 30 days more than they are paying suppliers. Secondly, it is possible to trade out of a financial crisis but more than likely, the problem will become bigger. The problem isn’t profit or selling, the problem is a mismatch on cash. Even if the business owner had money invested at the start, any increase in trade with this sort of mismatch will lead to more cash needed to keep the business afloat.
This problem is all too common and sadly we accountants don’t always help much! Firstly, the year end accounts that we produce for Companies House don’t really tell you about profit. We could give you a ‘cash flow statement’ which shows you the link between profit and cash (it is all about timing) but they won’t really tell you too much about how to correct the situation.
Secondly, because we as accountants are obsessed with profit, sometimes the whole cash situation is not even picked upon. I can tell you many stories of how year end accounts have been correct from an accounting perspective but utterly useless in telling a business owner where they stand cash-wise.