One of the recurring questions that I get asked by business owners at the end of the year is ‘If I have made this much profit, why do I not have any money in my bank account to show for it?’ Well the short answer is Profit does not equal Cash.
A good place to start to explain this is with the definition of both words.
Profit is an excess of revenues over the outlays and expenses in a business enterprise over a given period of time, usually one year.
Cash is defined as money in the form of banknotes and coins usually issued by the government.
Every set of accounts is made up of a Profit & Loss Account (P&L) / Income Statement and a Balance Sheet. The P&L is a record of the income / turnover of the business less any business expenses incurred exclusively used for the running of the business for a given period of time, usually a 12 month period. The P&L is reset to zero at the beginning of each new period. On the other hand, the Balance Sheet is a continuous report that looks at the assets and liabilities / debts of a business on a specific date.
Many new business owners assume that everything that they spend their money on is a business expense and will be used to reduce the profit of the business at the end of the financial period, this is not the case. Typical business expenses includes items such as telephone costs, motor expenses, stock purchases, accountancy fees etc. Other items you may spend you money on that are not a business expense for the P&L are business assets (ie computers, office furniture etc), loan repayments excluding the interest portion, and VAT payments (and receipts). Alternatively, if you have taken money from the business for your personal use other than a salary or dividend, then this too is excluded from the P&L.
A further reason why profit is not equal to cash is because your business accounts should be a reflection of the business’ financial position at a particular moment in time. This therefore means that you will need to account for items that you may not as yet have paid for or been paid for by a customer however you have a commitment to follow through for example you may have received items of stock on the last day of the period but not paid for it as yet as you have a credit account with the supplier. In this case you will need to ‘accrue’ for the expense in the accounts. The other side of the coin is where you may have paid for services in advance of receiving them such as with a software licence fee payable each year. You may pay for the whole year in advance but have only benefitted from 6 months at the period end, you therefore will ‘prepay’ the later 6 months and reduce the cost in the P&L and increase the profit.
Hopefully I have not waffled too much and you can see by the above the reason why your bank balance does not reflect your profit at the end of the year. I am always happy to answer questions if you have any.
In the meantime I would like to leave you with an old saying as food for thought: ‘Turnover is vanity, Profit is sanity, Cash is king’.