You made a profit but the money is not in the bank. Where did it go?
Many people assume that profit and cash are one in the same. But in business, they are very different metrics, each with a different meaning.
Understanding the difference between the two and how to manage them is vital to the financial health of your business.
What is Profit?
Profit is simply your revenue less your expenses. The profit or net revenue is how much money is left after you have paid all of your business expenses.
If you operate a computer system with debtors and creditors your profit will include invoices to your customers which may not have all been paid and invoices from your suppliers that you may not have paid yet. These have an impact on your profit although you have not yet received payment.
If your business owns fixed assets then you will have a depreciation expense in your profit and loss statements (Statement of Financial Performance). Depreciation represents a charge for using the fixed assets during the year and does not equal a cash outlay during the year.
Long story short: Your profit does not equal the cash in the bank.
What is Cash?
Cash is the physical cash coming into the business from customers and owners less the cash flowing out of the business to suppliers, staff, Inland Revenue and owners. You need cash coming in to pay the business expenses.
If there is only enough cash coming in to meet the expenses with none left over, the business is surviving but unable to grow. If there is not enough cash to pay the bills, this is negative cashflow. That can sink a business much more rapidly than you may anticipate.
For a successful business, the amount of cash coming in must be greater than the expenses.
Unlike profits, cash refers to the actual money you have at any one time, in your bank account.
How Profit and Cash affect business
A common way to describe the effects of cash and profits is comparing them to food and oxygen.
Cash is similar to oxygen. We need a constant supply of it to survive, and cannot last long without it. Profit, on the other hand, is more akin to food. Although it is essential for long-term survival, we can go without it for a short time. And of course, we need both things to thrive, not one or the other.
Cash flow and profit are not necessarily connected. Just because your business is profitable doesn’t mean the cash flow is positive.
Timing can be everything in business. Get things wrong, and even a profitable venture can fold. If you can’t pay your bills because you have no actual cash in your accounts, that’s a problem – even if you have profits on the way.
Expenses that you pay that affect cash but not profit include payments to the Inland Revenue Department for income tax and GST, capital payments on business loans and hire purchase agreements, and the big one personal drawings.
Striking that delicate balance between profitability and positive cash flow is all about careful financial management and timing. You need to show a profit to grow your business but must maintain that positive cash flow to keep it going day-to-day.
If you are looking to expand your business or gain a business loan lenders will look at both the profit and cash flow of the business.
Ensuring you get your finances right can be time-consuming and often confusing. The use of accounting software such as Xero, can help you keep on top of the cash side of the business with automated bank feeds and cash reporting. Cash profit & loss and cash flow reports are a good place to start with your business financial management.
Remember the cash profit is not the full profit for the business. To have an accurate idea of your profit regularly you need to keep track of your debtors and creditors and factor these into your reports. Accounting software can integrate this into your financial reports.