It’s a question we hear from business owners more often than you might think.

“The accounts say we made a good profit, so why doesn’t it feel like there’s any money in the bank?”

It’s a fair question. And usually, there isn’t one simple answer.

Profit and cash are two very different measures of how a business is performing. Understanding the difference between them can tell you a lot about what is really happening inside your business.

Profit doesn’t necessarily mean cash in the bank

Your profit and loss statement measures the financial performance of your business over a period of time. Broadly speaking, it takes your income, subtracts the expenses incurred in earning that income and arrives at a profit or loss.

But not everything that happens to your bank account appears as an expense in your profit and loss statement.

And not everything included in your profit has necessarily arrived in your bank account yet.

That distinction is where the answer often lies.

You’ve made the sale, but haven’t been paid

For businesses that invoice customers, revenue may be recognised before the customer actually pays.

Imagine you invoice $100,000 worth of work in June. That revenue may contribute to your profit, but if $60,000 of those invoices is still outstanding, the cash isn’t sitting in your bank account.

As a business grows, this can become increasingly important.

More sales can mean more money tied up in debtors. If customers are also taking longer to pay, a growing and profitable business can actually find itself under increasing cash-flow pressure.

This is why managing debtors and payment terms matters just as much as generating sales.

The money might be sitting on your shelves

Stock can have a similar effect.

A growing business may need to purchase more inventory to support increasing sales. The cash leaves the bank when you pay your suppliers, but unsold stock remains an asset of the business rather than immediately becoming an expense.

So you can have a profitable business with a substantial amount of its available cash effectively sitting in a warehouse, storeroom or showroom.

Too much stock, slow-moving stock or purchasing too far ahead of demand can all place pressure on cash flow.

You’re paying back debt

Loan repayments are another common source of confusion.

The interest component of a business loan will generally be an expense, but repayment of the amount originally borrowed is not.

So if your business makes a $5,000 loan repayment, the full $5,000 leaves the bank account, but only the interest component affects the profit shown in your accounts.

For a business carrying significant equipment, vehicle or acquisition finance, the difference can be substantial.

You’ve bought assets

Buying a vehicle, piece of machinery, computer equipment or other business asset can also use a significant amount of cash without the full purchase price appearing as an expense in your profit and loss statement at that time.

Depending on the circumstances, the asset may instead be recorded on the balance sheet and its cost recognised for accounting purposes over time through depreciation.

Again, the cash has gone out the door, but your reported profit doesn’t necessarily fall by the same amount.

Then there’s tax

GST, PAYG withholding, income tax and superannuation are another important part of the cash-flow equation.

Some of the money sitting in a business bank account simply isn’t available to spend.

GST collected from customers, for example, may need to be remitted to the ATO after taking account of applicable GST credits. PAYG withholding deducted from employee wages also creates an obligation to the ATO.

Businesses can run into difficulty when these amounts are treated as part of their available operating cash rather than money that will need to be paid when the relevant obligation falls due.

A profitable quarter can therefore be followed by a sizeable BAS or tax payment.

That doesn’t mean the profit wasn’t real. It means some of the cash generated by the business was always going to have another destination.

And then there’s the money you take out

For many small and family businesses, there is another piece of the puzzle: money leaving the business for the owners.

Depending on the business structure and circumstances, this could include wages, drawings, dividends, distributions, loan account movements or other payments.

The tax and accounting treatment differs between structures, but the cash-flow effect is simple. Money that leaves the business is no longer available to fund its operations.

This is one reason we think it is important to look at the business and the owners together rather than treating them as completely separate financial conversations.

Growth can actually make the problem worse

This is perhaps the most counterintuitive part.

A business can be growing, profitable and still experience serious cash-flow pressure.

Growth often needs to be funded before the resulting cash arrives.

You may need more employees, more stock, larger premises, additional vehicles or equipment, increased marketing and higher supplier payments before customers pay you.

The faster the business grows, the more working capital it may require.

So when someone says, “Sales are up 30%, but we seem to have less cash than ever”, that isn’t necessarily a contradiction.

It may be exactly what the numbers are telling us.

So where did the money go?

When we look at this question with clients, the answer is usually found by looking beyond the profit and loss statement.

We might look at:

• how quickly customers are paying
• how much cash is tied up in stock
• loan and finance repayments
• asset purchases
• tax and superannuation obligations
• money being taken from the business
• changes in creditors and supplier terms
• upcoming commitments
• the amount of working capital needed to support growth.

Most importantly, we want to understand what happens next.

Historical accounts tell us where the business has been. A cash-flow forecast can help us see what may be coming.

Profitability still matters, but it isn’t the whole story

None of this means profit isn’t important. A business ultimately needs to generate sustainable profits.

But profit alone doesn’t tell you whether there will be enough cash in the bank to meet wages next month, pay the next BAS, replace a vehicle or fund the next stage of growth.

For company directors in particular, cash flow also has another dimension. Directors have an obligation to remain informed about their company’s financial position and to prevent the company from incurring debts if it is insolvent. Poor cash flow, overdue creditors, problems collecting debts, increasing debt and overdue tax or superannuation can all be warning signs that deserve attention.

The earlier those signs are recognised, the more options a business will generally have.

So if your accountant tells you that you’ve had a profitable year and your first reaction is, “That’s great, but where did all the money go?”, don’t be embarrassed to ask the question.

It may be one of the most useful conversations you have about your business.

At Indigo Financial, we work with business owners to understand not only what their numbers say about the year that has passed, but what those numbers mean for the decisions ahead.

Talk to us if you would like to take a closer look at what is driving the cash flow in your business.

Contact Indigo Financial on (08) 8212 8585 if you need help with understanding any of your accounting, taxation and business development needs.

Sources
Australian Securities and Investments Commission (ASIC), Insolvency for directors
Australian Securities and Investments Commission (ASIC), For businesses facing financial difficulties