Why does your bank balance never seem to match your profit? In this episode of Beyond the Numbers, Bev explores the key differences between profit and cash flow – and why confusing the two can lead to serious financial stress.
She explains the impact of VAT, loan repayments, asset purchases, and more, and shares three practical strategies to improve your cash flow and build a more financially resilient business..
The Dilemma: Bank Balance vs. Profits
You’re a business owner, poring over your year-end accounts, and the numbers suggest a profit. Great news, right? However, a cursory glance at your bank account spawns panic.
Where’s the cash? If this scenario sounds all too familiar, rest assured, you’re not the only one riding this rollercoaster.
Understanding why your bank balance and profits don’t seem to align is crucial. It’s a common source of frustration among entrepreneurs and one of the financial world’s perplexing puzzles. But fret not – we’re here to clarify this conundrum in a way that truly makes sense.
Turnover, Profit, and the Harsh Reality of Cash Flow
There’s an old adage in business: turnover is vanity, profit is sanity, but cash flow is reality. Turnover accounts for total sales, while profit is what remains after deducting the costs of selling and administrative expenses.
However, cash flow represents the actual movement of money in and out of your business. A staggering report by Xero in 2022 suggested that businesses, on average, wrestle with cash flow challenges for over four months each year.
So, why doesn’t a healthy profit always equate to cash in the bank? Let’s examine a few reasons:
- VAT: It affects your cash balance but not your profit. It’s not your money, yet you handle collecting and remitting it.
- Loan Repayments: These reduce your cash without affecting profit, though interest does impact both.
- Asset Purchases: A costly asset impacts cash outflow but is depreciated over time, affecting profit incrementally.
- Stock: It impacts profit for the amount you utilise and purchase during the period, but holding stock impacts cash outflows.
With these in mind, even a profitable month can leave you without spare cash after making tax payments, loan repayments, and asset investments.
The Cash Conversion Cycle
Consider a service-based business like a marketing consultant. Work begins on day one and may take up to 35 days, incurring various costs. Invoicing might occur on day 35, with terms giving clients 60 days to pay, though actual payment could take 75 days. This results in a staggering 110 days of tied-up cash.
For retailers, purchasing stock means cash could be tied up for 30 days after payment terms or longer when considering customer payments.
Learning from Real-World Scenarios
Businesses often learn the hard way about the difference between profits and cash.
Confident after seeing £300,000 in their account, one such business invested £150,000 in new equipment, a decision that seemed sound – until tax payments and other expenses quickly led to a cash flow shortage.
Strategies to Free Up Cash
To alleviate cash flow blockages, consider shortening customer payment times, evaluating supplier terms, and reducing stockpiling. Audit overhead costs and expensive borrowings, and take a closer look at your business model’s cash conversion cycle.
Most importantly, plan for taxes consistently; put aside VAT as it’s collected and budget for corporation tax monthly, based on when they are due.
Three Tips to Avoid Cash Flow Nightmares
Managing cash flow is critical to keeping your business running smoothly. Profit matters, but businesses often fail because they run out of cash. Here are three essential strategies to protect your finances:
1. Keep a Cash Flow Buffer
Maintain at least three months’ worth of operating expenses in reserves. This acts as your safety net for unexpected challenges like delayed payments or sudden expenses. Start small by setting aside a portion of your profits and adjust your buffer as your business grows.
2. Forecast Cash Flow Weekly
Track money coming in and out with tools like Xero or a simple spreadsheet. A weekly forecast lets you spot potential shortfalls and make proactive decisions. It also helps you identify trends and opportunities to improve your cash management strategy over time.
3. Invoice Promptly and Enforce Payment Terms
Send invoices immediately after providing products or services. Shorten payment terms (e.g., 14 or 30 days) and encourage on-time payments with incentives like discounts for early payments. Consider using direct debit systems for faster, automated cash flow.
Final Reminder: Businesses fail not because they’re unprofitable but because they run out of cash. Follow these tips to stay ahead of challenges, and tune in to the next podcast episode for strategies to eliminate cash flow anxiety for good!
Transcript
Welcome to Beyond the Numbers, the podcast where we take the stress out of business finance and break down the numbers in a way that actually makes sense.
Today, we’re tackling a big frustration for business owners: why does your bank balance never seem to match your profits?
Have you ever looked at your year-end accounts and thought “Great I’ve made a profit.” but then checked your bank and panicked because there’s no cash? Well, you’re not alone. This is one of the biggest confusions in business finance, and today I’m going to break it down in a way that makes total sense, no jargon, just real talk.
So, let’s start with a classic saying that you may have heard before: turnover is vanity, profit is sanity, but cash flow is reality.
So, turnover is your total sales, all the total money coming in, profit is what’s left over after your costs of selling and your admin expenses, but cash flow is the real movement of cash coming in and out of your business.
A report by Xero suggested that, on average, businesses face cash flow challenges for over 4 months each year, so okay, let’s turn to the flip chart. So, why does profit not always mean cash?
Imagine you’ve had a great month, you’ve made a profit on paper, but why isn’t there money in your bank?
So let us take a look at the difference between cash and profit. VAT affects your cash balance, but not your profit. This isn’t your money, but you’re responsible for collecting it and paying it.
Loan repayments only impact cash; it doesn’t impact your profit at all.
However, the interest payments affect both, and then imagine you’re buying a bit of kit, say it costs you £100, the initial price of this asset purchase obviously impacts your cash, but if it costs you £100 and say it’s going to last you 5 years, the depreciation is what impacts profit.
We’d be taking that at £20 each year for the next 5 years. Next up is stock. Now, stock does impact profit for the amounts that you utilise and you’ve purchased during the period, whereas stock that you’re actually holding at the year end or at the end of a month is actually, of course, only cash payments.
So, from this, you can see even if you’ve made a healthy profit, there may be no cash left over after making tax payments, loan repayments, and asset purchases.
Now that we know the difference between profit and cash, let’s talk about why money gets stuck in your business.
So I want us to take a look at the cash conversion cycle of a service business, let’s take a marketing consultant, so we start the work when the client signs the proposal, perhaps on day one, we may work on this for about 25 days and we’ll be spending money on salaries contractors and perhaps other purchases.
Then we complete the invoice on day 35, so another 10 days later, this means we’ve got work in progress for a whole 35 days.
Now, we may have terms for invoicing our clients on 60-day payment terms, but actually, they may take 75 days to pay, so that means we’ve got 75 days plus the 35 where we have work in progress, so that’s a staggering 110 days where our cash is tied up.
So if we think about this from a retail perspective, imagine you’re buying clothes ready to resell in your shop, you make your stock purchase on day one, but perhaps you’ve got payment terms of around 35 days with your supplier, you may know though, that you hold on to your stock for an average 65 days.
Our cash is tied up in the business, 65 take your 35 that you’ve had from your supply term, which means we’ve got 30 days of cash tied up in your business.
Now, if you’re a wholesaler, you may extend this by the fact that you may have an extra 30 days for your customers to pay you, so if this then takes a further 30 days, your cash is tied up for a total of 60.
I want to talk about a real-world example, so let’s talk about a business that learned the hard way about the difference between profits and cash.
Imagine a business that’s had a couple of fantastic months, sales are booming, profits are looking strong, and then when they looked at their bank account, there was £300,000 sitting there.
They felt confident and decided to buy a new piece of equipment they’ve been after for a while, and they paid for it outright, £150,000, paying cash at the time, which seemed like a great idea, no finance costs, no debt, but here’s what happened next.
They also needed to pay VAT and took out a loan for owner drawings. Additionally, their business had a long working cycle, meaning all expenses were being paid out first, and it took a long time for customer payments to cover these costs.
Before they knew it, there was a cash crunch, bills were due, staff needed paying, and suddenly they had no buffer left in the bank on paper.
Their business was still profitable, the profit and loss account looked healthy, but in reality, they were scrambling to make payments.
They had to dip into their overdraft, negotiate with suppliers, and cut back on essential marketing.
So, what can we do about shortening this working capital cycle and keeping cash in our business? Let’s look at things surrounding customers.
We can shorten customer payment times, we can start requesting payments upfront to help support with those initial ongoing costs and make sure you’re reviewing your terms and conditions and really consider, have you got your pricing right now in terms of your purchases?
Start looking at your suppliers’ terms. Can you extend this payment date? Have you got the best deal available, and also stockpiling, make sure you’re not holding on to too much stock?
See if you can move to more of a just-in-time basis now, in terms of other costs, have you got expensive borrowings? Are you taking a little bit too much out?
Are there overheads that perhaps are creeping up that you hadn’t even thought about?
One thing that catches a lot of businesses out is tax, because let’s be honest, when cash is tight, it’s easy to spend the money without realising it’s not actually yours.
We’re calling it the VAT trap. Every quarter, HMRC wants their share of your sale. If you’ve already spent the money, you’re likely to be in a cash flow crisis.
A great way to operate is to segment 20% straight away and put that VAT money in a different account, and also start planning for your corporation tax on a monthly basis, so if you’re a 31st of December year end let’s have a think about when your taxes may be due.
You may be paying your PAE on a monthly basis or quarterly, and let’s assume that your VAT is in line with your year-end end so this means you’ll be paying your VAT on the 7th of February, 7th of May and 7th of August.
You’ll then also pay corporation tax on the 1st of September, and then back into another VAT payment on the 7th of November, and this cycle will continue.
Three key tips to avoid these cash flow nightmares: the first one is to keep a cash flow buffer, aim for at least 3 months’ worth of expenses and reserves for that rainy day fund. Tip two: forecast cash flow weekly.
Use something like Xero or a simple spreadsheet to track your cash coming in and out over the next 90 days.
Tip three: invoice immediately. Set clear payment terms and use direct debits if possible.
Remember, businesses don’t fail because they aren’t profitable; they fail because they run out of cash. Don’t be one of them.
Next episode, we look at how to stop cash flow anxiety for good, giving you some practical strategies to get control over your cash flow once and for all.
