Why have we no money in the bank?

This is a question that many of our clients have asked us, usually when we tell them that they have a tax bill to pay …” You say that I have made a Net Profit of £XXX, but where is it? Why do I have to pay tax when I have no money in the bank?”.

For many business owners, the concept of Profit is a mystery, especially when they compare it with cash in the bank.

Obviously, it is good thing to make a profit; essentially, that is what a business is all about. However, it is often the case that there is profit, but no money in the bank account. How can this happen?

The Answer is simple: PROFIT IS NOT CASH.

The key thing to understand about profit is that it has no connection to how much cash is in the bank.

What is a Profit and Loss Account then?

A Profit and Loss Account shows the movement of transactions which occur in your business during a specified period, often the financial year for tax purposes. The total net effect of these transactions is the profit (or loss) that you see on your accounts.

For example; if you make a sale and generate an invoice amount of £1,000 in your books, your Profit and Loss Statement shows the amount of the sale and resulting profit, but there is NO CASH in the bank, until the invoice is paid.

So, outstanding invoices (debtors), will increase your profit but will not increase the cash in your bank. Then, when this invoice is paid, the money remains in your bank, but, only for a period of time, because when you pay your suppliers or pay your bills, the money is being used up.

Take Loan Payments as another example; most business owners forget that only the interest portion of a loan payment appears on a Profit & Loss Statement, while the principal portion of the transaction occurs on the Balance Sheet. So, if you have a loan payment of say, £500 monthly, and the interest portion of the repayment is £50 per month, only the £50 will appear in the Profit and Loss Account, but the whole £500 in cash will have left your bank account.

Examples of other things which reduce your cash but do not appear on your profit are:

Capital Purchases;

when you make, a large capital purchase the money leaves your bank but does not appear on your Profit and Loss Account because it is a Balance Sheet transaction which increases the value of the business.

Drawings and Dividends;

This is money taken from the business directly to the owners.  Drawings and dividends reduce the value of the business and, again, are a Balance Sheet transaction so they affect your cash balance but do not affect your profit in the Profit and Loss Account.

In conclusion;

it’s not magic; It’s just having a basic understanding of how transactions occur in your business and their effect on your Profit & Loss Statement, as well as your Balance Sheet.

The goal, in understanding how transactions occur, is to make better financial decisions.  You can be profitable and still be broke.

A wise Bank Manager once said to us “Profit is Vanity, Cash is Sanity”.  Turning Profit into Cash is the secret to managing your business successfully.

Next time we will talk about how you can turn your Profits into Cash.

If you need help with understanding your financial reports, why don’t you contact us, info@clearaccountingni.com or give us a call on 02891 072561? We would be glad to help you