What’s the Difference between Cash and Profit and Can a Business Be Profitable But Still Run Out of Cash?
So, you want to know how a company can be profitable but still run out of cash? This article courtesy of Brixx is a terrific place to start.
Part of the answer is that profit is different from cash. However, it’s not as simple as that.
To answer this question, we’re going to need to fully understand what cash and profit are and their differences.
In this article, I’ll delve into the Cash Flow and Profit & Loss reports to understand why profitability doesn’t mean cash.
What is Cash and Profit?
Like I said earlier, cash and profit are different. In fact, they are so different that if you get them confused it can actually be detrimental to the health of your business. Scary, right?
So, before we get into why profit doesn’t equal cash and vice versa, it’s important we understand what each one is.
What is cash?
Cash is the money you receive when a client actually pays you or when you actually pay for expenses. It’s important to let this sink in, as it is one of the main differences between cash and profit. I’ll demonstrate this with some examples later on.
Cash is shown on the Cash Flow Forecast (no surprise there) which depicts the movement of cash in and out of your business. The Cash Flow Report shows when the movement of cash actually happens, rather than when a transaction takes place. Think about cash in a bank account, that’s how the CF works.
What is profit?
Profit is the value that your company gains from providing goods or services, and is displayed on the Profit and Loss Report. This report shows when your company makes transactions and the figures associated with income and expenses.
Profits occur when you have more value coming into your business than leaving it, so the calculation is:
Income – expenditure = profit
However, profit is displayed when a transaction happens rather than when you actually receive the cash.
Cash vs Profit – what are the differences?
So we know what cash and profit are now, what are their differences?
The big difference, which can cause woes for business owners, is how profit and cash are actually displayed. Looking at profit alone paints a very different picture compared to looking at cash.
Let’s look at two examples. The first being about the differences in timing between cash and profit, and the second being about the reporting of the movement of value.
Example 1: The differences of timing between cash and profit
Let’s say I’m a plumber who owns a sole trader business.
I go to a customer’s house in August and repair their toilet. I charge £500, and they agree to pay it the next month in September. How does that look on the reports?
Here is my Profit and Loss Statement. Notice that even though I haven’t’ received the cash, the revenue is still reported on the P&L from when the transaction actually happened. This reflects when I delivered the service.
How does this look on the Cash Flow Report?
Here’s my Cash Flow Report. Unlike the P&L, the £500 transaction is appearing in September rather than August. This is when the cash is actually received from the customer rather when work has been done.
This is the big defining difference between cash and profit. Cash is displayed when you actually receive it, profit is displayed when the transaction is first noted on records.
So we’ve covered what income of cash looks like, but what does a purchase of an asset look like?
Example 2: The differences between cash and profits and losses
Let’s say I want to purchase a new van for £8,000 in August.
As you can see,I have an £8,000 cost entering Cash Flow Report in August. This is because the cash paid out is reported immediately. Let’s have a look at the Profit and Loss report.
Wait what? Where’s the big £8,000 cost? Well, the P&L doesn’t actually display the purchase of the van. This is because it displays profits and losses. But what do I mean by this? Well, as the P&L displays only value gained or loss, I’m spending £8,000 on a van which is worth £8,000.
Therefore, the cash investment is equal to asset value, meaning no profit or loss has been made. This is why it isn’t being displayed on the Profit and Loss report.
All of this leads nicely onto the big question at hand.
How can a business be profitable but still run out cash?
In the last section, we went through about how profit and cash is displayed on reports. The answer to this question is all about costs and expenses.
Some people make decisions on costs based on profit alone, which is a big no-no when coming to running a business, for the simple fact that it could lead to you running out of cash.
I’ll take you through the example of me being a plumber again.
Let’s say I’m starting a plumbing business. I’ve got my tools, insurance, and everything else I need to have a healthy running business. I also have £200 in my bank account.
So I go to a customer’s house, I spend £100 on parts needed to make the repairs, and the customer agrees to pay me £500 a month later.
What do the reports look like?
The P&L is reporting I make £400 in gross profit in August, which is true. Remember, this is profit, not cash. I’m not making £400 in cash in August.
Here’s the Cash Flow report. You can see in August I’m paying £100 for the parts, yet I’m still not receiving the money for the service until September. This is a negative cash flow as I’m making a loss in one month.
Remember, what I said earlier. I only have £200 in my bank account. What would happen if I had a sudden expense? I could run out of cash, or even end up in debt!
It can be detrimental to your business’ health if you’re making decisions about cash based on your Profits. Your business can be profitable but you can definitely run out of cash.
But how can you avoid this happening to you?
How can I prevent my business from running out of cash?
The simple answer to this question: Forecast your cash flow.
It’s so important to forecast your cash flow to give you a better understanding of your future costs and income. A forecast allows you to create scenarios, such as running out of cash, and learn from them to prevent them from ever happening in the first place.
But we don’t just think Cash Flow is important – the Profit and Loss report gives insights the Cash Flow doesn’t, and the Balance sheet provides the missing pieces of the puzzle, explaining the business in a whole new light. The truth is you need 3-way forecasting, also known as “the three main financial statements”, to get a full picture of your business’ future.
Article courtesy of Brixx