How can I have made a profit when I have no cash in the bank?
It's a common question that many business owners find themselves asking: "How can I have made a profit when I have so little cash in the bank?"
We often get asked this question too by clients and it’s easy to get confused. You see a healthy profit on your profit and loss statement, yet your bank account balance doesn’t reflect it.
The simple answer - it's all about timing.
Let’s break down the reasons and explore how you can manage your cash flow more effectively:
When you pay and when you get paid
The first thing to understand is that your business’s profits are calculated using the accrual accounting method. Accrual accounting recognises sales and purchases at the time they are made, NOT when the cash is actually received in the bank. This method provides a more accurate picture of your business's true profitability during a specific period, but it can also lead to confusion when it comes to cash flow.
Sales
Suppose you made a sale in December, but the customer pays you in January. Under accrual accounting, that sale is recorded in December, increasing your profit for that month, even though the cash hasn’t hit your bank account yet.
Purchases
Similarly, you might have received goods or services in December and recorded the expense, but you don’t pay for them until January. The expense reduces your profit in December, even though the cash doesn’t leave your bank account until the following month.
Drawings
If you’re self-employed or operating through a limited company, another factor that can affect your cash flow is drawings. Drawings refer to money taken out of the business for personal use. While these withdrawals reduce the cash available in your business, they don’t appear on your profit and loss statement.
Sole-trader
As a sole trader, the money you draw out for personal expenses reduces the cash in your business, but it doesn’t reduce your profit since it's considered a distribution of profit rather than a business expense.
Limited Company Director
If you're a director, you might take money out of the business as dividends or director’s loans. These reduce the available cash but don’t affect the reported profit in the same way business expenses do. Just make sure you’re not taking out too much as this can lead to tax implications and personal liability. Speak to a professional if in doubt.
Late paying customers
Another common reason for discrepancies is customers who owe you money. You’ve done the work, sent the invoice and recorded the sale as income in your accounts, however, that income hasn’t yet translated into cash in the bank.
Late payments can severely impact your cash flow, and you might find yourself with not enough cash to cover your expenses, despite what it may say on paper! If late payments are a recurring issue, implement stricter payment terms, set reminders or offer incentives for early payment.
Finance repayments
If your business has taken out a bank loan or is repaying other credit agreements for purchases like vehicles or equipment, these can make a real dent in your bank balance. Income received from a bank loan or similar won't hit the profit and loss in your accounts but similarly, the repayments won't either although you can offset the interest paid.
Prepayments and big bill
Some expenses, such as annual insurance premiums or software licences, are paid upfront but cover a longer period, falling outside your accounting period. In accounting terms, these are applied as prepayments so that the cost is apportioned across the period to which it relates rather than hitting your accounts in one lump sum. The same goes for big asset purchases - these represent a significant investment and the cost of these is allocated as an asset in the balance sheet and so won't be shown in your accounts until you (or your accountant!) make the necessary adjustments to split the cost of an asset purchase over its useful life.
These factors can make your cash balance look lower than expected, even if your business is showing a profit.
Saving for tax bills
Finally, and most importantly, a common pitfall for many business owners is forgetting to set aside cash for their tax bill! Taxes, whether it’s income tax, corporation tax, or VAT, can significantly impact your cash flow.
We recommend setting aside a portion of your income every month to cover taxes. This can vary depending on each business, so get advice from a tax professional to determine exactly how much you need to save based on your business setup and tax requirements.
Income and Corporation Tax
These taxes are based on the previous year’s profits, meaning the cash to pay them comes from your current reserves. This can create a strain, especially if your cash flow is already tight.
VAT
If you’re VAT registered, the VAT you collect on sales isn’t yours to spend. It’s easy to forget this and reinvest it into the business, only to find yourself short when it’s time to pay HMRC. Setting aside the VAT portion in a separate account can help prevent this issue. Don't forget VAT needs to be paid quarterly to HMRC!
The key takeaway is that profit and cash flow are not the same! Understanding the timing differences between when transactions are recorded and when cash changes hands is crucial for managing your cash flow effectively.
If you are worried about your business cash flow or how to manage this better so you’re never caught short, get in touch to see how CB Accounting can help.
