A very common question I am asked by non-finance directors is why they can’t see their profits in their bank account. The simple answer is profits and cash are not the same thing!
The Profit and Loss Account (sometimes now called Statement of Comprehensive Income) recognises sales when they are earned and costs when they are incurred rather than when any cash is paid or received. The P&L doesn’t actually care when cash is paid or received.
Sales are usually recognised when sales invoices are raised, for example. However, how long does it take for your sales invoice to be paid by your customer? 30 days using standard terms and conditions, perhaps longer if you have a slow-paying or difficult customer.
The same applies to costs – they are recognised on the P&L when they are incurred. For example you have travelled to an expensive conference at the other end of the country and these costs need including in the month in which this happened on your P&L, not because any cash has been paid.
Therefore, there is firstly a timing difference between when sales and costs are recognised on the P&L to when physical cash is received or paid.
Secondly, your fabulous finance team put several accounting adjustments into the finance reports during their ‘month end’ process. These adjustments help you understand the financial performance of the company better but it must be recognised that many of these month end adjustments are not cash. For example, you will see a line called ‘depreciation’ in your finance reports. Depreciation is the best estimate of the reduction in value of your assets, e.g. motor vehicles. This shows in the accounts correctly that your assets are losing their value and are worth less as time goes on. However, this is not cash, the business is not paying anyone anything for this reduction in value of your assets. Therefore profits and cash are not the same because these month end adjustments are only paper adjustments, no cash is paid or received.
And finally, not everything you buy with cash in the business appears on your Profit and Loss Account. When you purchase assets, such as motor vehicles, these items appear as Assets on your Balance Sheet (sometimes now called Statement of Financial Position). This is the third key reason why cash and profits will never be the same.
To summarise, profits will never be cash in the bank because:
1. Timing differences between when sales & costs are recognised in the P&L compared to when cash is received and paid.
2. Month end adjustments posted to the P&L are not cash, just paper adjustments.
3. Cash is spent on items that do not appear on the P&L, they appear as assets on the Balance Sheet.
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