Profit does not equal cash. Profitable businesses regularly fail because they run out of cash.
The relationship between profit and cash is one of the biggest misunderstood concepts when it comes to understanding your cash flow.
Have you ever found yourself asking where all the cash is after a profitable month or year?
The best way to understand this is for me to show you an example.
CreativeWeb Solutions is a digital agency offering web design, SEO, and digital marketing services. The following is a simplified P+L for the month of July.
Sales £50,000
Cost of Goods Sold (COGS): £20,000
Freelancer Fees £10,000
Advertising Spend on behalf of clients £10,000
Gross Profit (Sales - COGS) £30,000
Overheads: £16,000
Operating Expenses £15,000
Depreciation £500
Interest £500
Net Profit Before Tax (Gross Profit - Overheads) £14,000
At a quick glance, most would be very happy with this performance, a profitable month, and expect to end the month with a healthy bank balance. However, taking a look at the cash flow for this month tells a different story.
Starting Bank Balance £40,000
Cash Inflows: £20,000
Cash received from last month’s sales £5,000
Cash received from this month’s sales £15,000
Cash Outflows: £66,000
Freelancer Fees £12,000
Advertising Spend £10,000
Operating Expenses £18,000
New Laptops for staff £5,000
VAT due £9,000
Loan Repayments £2,000
Owners Dividend £10,000
Closing Bank Balance £-6,000
Despite a profitable month, they had a negative cash flow of £26,000, ie £26,000 more went out than came in. As they started the month with £20,000, this left them overdrawn by £6,000.
Where did it all go wrong?
Several factors caused this:
Agreed payment terms on sales invoices are for 25% to be paid upfront and the remainder due the following month. They had low sales last month, so they didn’t receive much cash this month.
VAT - they forgot that the P+L report shows figures net of VAT. The freelancer fees and operating expenses all had 20% VAT on top that needed to be paid. The sales also had 20% extra on top, but they only collected 25% of sales this month.
They had a capital expenditure of £5,000 on laptops. This shows up on the P+L as depreciation but is spread over three years, the cash flows out all in this month though.
They have an outstanding loan that needs to be repaid each month. Only the interest portion of the loan shows on the P+L. The majority of the repayment is capital and, therefore, can’t be seen on the P+L.
They pay VAT every quarter, and it was due this month.
The owner looked at the profit for the month and made a decision to pay himself a dividend of £10,000. Looking at the P+L in isolation, this appeared OK, but in reality, the business couldn’t yet afford it from a cash flow perspective.
You can see how big the gap between profit and cash can be.
Remember profit can be adjusted and manipulated by accounting policies and journals, cash can’t. Your bank balance does not lie!