Cash vs Profit: why are they not the same?
A question I always ask when delivering financial training is “why do cash and profits differ?” The answers are wide-ranging but never, so far, correct.
Cash and profits in companies are different for two key reasons:
- Timing differences between when income and costs, and therefore profits, are recognised in the profit and loss account (P&L) and when cash is received or paid.
- There are ‘paper adjustments’ put through the profit and loss account each month. These include items such as depreciation, amortisation, accruals, prepayments and provisions. More about these in the next blog.
In this blog, we’re going to look at the timing differences between cash and profits and the impact this has on a business.
When a sales invoice is raised in a company, this is the point it hits the profit and loss account. The moment the sales invoice is raised, it shows as Income on your P&L. However, the physical cash for this invoice may not be received for another 30 days or longer, if the customer doesn’t pay on time.
Equally, when an entity enters a purchase invoice on its system, this is then recognised as a cost on the P&L. Again, the physical cash to pay for this invoice may not be released for another 30 days, depending on the credit terms offered by the supplier.
Let’s have a look at the following example:
Smith Jones & Dipstick have raised 3 sales invoices to 3 different customers and they’ve received 3 purchase invoices from their suppliers for various different services.
Their P&L looks very healthy with a positive balance. But how does their cash position fare?
The cash position for their company does not look healthy at all. Firstly, there is the timing difference between when the sale is recorded on the P&L when the sales invoice is raised and when the money is received. Smith Jones and Dipstick offer 30 day terms but unfortunately (as sadly happens too frequently in business), their customers have paid late.
In the meantime, they have had to pay money out to their suppliers, pushing them into the red.
The profit and loss account shows a profit of £2,550 in month 2. The cash position does not catch up until month 5.
Why is it so important for businesses to be aware of this?
There are several reasons, the most important being your business could fail and go under because there is no cash in the bank, even though it is showing a profit. This happened to countless companies during the recent recession.
Equally, you could be making decisions based on your profitable status, such as investing in new people, premises or equipment. However, there would be no cash to support this intended growth.
Cash is king. Without physical cash in the bank, companies have no money to pay their salaries, pay their suppliers or invest in future growth.
Ensure you know and understand your cash position in addition to your profit or loss status in order to make stronger business decisions.
In next month’s blog, we look at the 2nd key difference between profit and cash, the ‘paper adjustments’ that are posted during the month end process and why we do this.
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