Profit vs Cash

One of the more disorienting experiences in business is being told you have had a profitable year and looking at a bank balance that does not reflect it. It is common, it is not a sign that something has gone wrong with the bookkeeping, and understanding why is one of the more useful financial skills an owner can pick up. It does not require a finance qualification. It requires understanding a handful of mechanisms.

The difference in one paragraph

Profit is an accounting measure: revenue earned minus costs incurred over a period, whether or not the money has moved. Cash is money that has actually arrived in or left the bank. The gap between them is almost entirely timing — revenue you have earned but not collected, money you have spent that sits on the balance sheet rather than in the profit and loss, and payments that never appear in the profit and loss at all.

The four things that never show in your profit

• Money owed to you. An invoice raised is revenue today and cash in 30, 45 or 60 days. Growing businesses fund that gap out of their own pocket.
• Capital repayments on loans and finance. Only the interest is a cost in the profit and loss. The capital element leaves the bank and appears nowhere in your profit.
• Tax payments. VAT is collected on behalf of HMRC and never was your money, though it sits in your account until the quarter is due. Corporation tax is usually paid nine months after a year end, so a good year produces a large cash payment long after the profit was recorded.
• Drawings and dividends. Money taken out by the owners, below the profit line, invisible in the profit figure.

A worked example: a profitable month that costs you £53,000

Illustrative figures. A business posts a good month: £18,000 profit before tax. Here is the cash:

• Profit before tax: +£18,000
• Debtors rose by £26,000 — two large invoices raised on 45-day terms: −£26,000
• Work in progress and stock up £4,000: −£4,000
• Quarterly VAT payment: −£19,000
• Corporation tax on last year's profit: −£11,000
• Loan capital repayment: −£6,000
• Owner's drawings: −£5,000

Net movement: −£53,000. A profitable month that consumed £53,000 of cash. Nothing has gone wrong and nobody has made a mistake. Every one of those items is normal. But an owner looking only at the profit and loss will not see any of it coming, and will experience the bank balance as a mystery.

Note also which items are within your control. The VAT and corporation tax are dated and predictable. The loan repayment is fixed. The £26,000 of debtors and the £4,000 of work in progress are the two you can actually influence, and they are the two most owners never look at.

Growth makes it worse, not better

Fast-growing businesses often have the worst cash positions relative to their profitability, because growth demands investment — more people, more stock, more capacity — before the revenue from that growth arrives. It is entirely possible to be profitable, expanding and three weeks from a serious problem at the same time. This catches out good businesses more often than bad ones.

Build a 13-week forecast

The single most useful financial tool for a small business is a simple rolling cash forecast. Not accounting software, not a finance director. A spreadsheet with a column per week for the next 13 weeks and three sections: money in, money out, closing balance.

List every expected inflow by week — invoices due, standing payments from clients, anything else. Then every outflow — payroll, rent, suppliers, VAT, PAYE, corporation tax, loan repayments, drawings. Carry the closing balance into the next week.

The value is entirely in the negative numbers. A week where the balance dips below zero, or below whatever threshold makes you uncomfortable, is a problem you can now solve eight weeks early: chase a specific invoice, ask a client to pay a stage early, move a purchase by a fortnight, or arrange a facility before you need it rather than during the week you need it. Solving it at eight weeks' notice is administration. Solving it on the day is a crisis, and it costs more.

Fifteen minutes at the end of each week to update actuals against forecast is enough to keep it useful. A forecast updated quarterly is a history exercise.

Three numbers to look at every month

• Debtor days. If your terms are 30 days and your debtor days are 58, roughly a month of sales is sitting with clients rather than with you. That gap is the cheapest money you will ever raise.
• Cash at the end of the next 13 weeks. One number from the forecast. If it is lower than this month's, find out why now rather than in ten weeks.
• Cash held against fixed costs. Bank balance divided by monthly fixed costs. It tells you how long the business survives if income stops, and most owners have never worked it out.

None of this requires new software. It requires ten minutes a month and a willingness to look at figures that may be uncomfortable — which is the actual obstacle, not the arithmetic.

The checklist

• Build the 13-week forecast this week. A spreadsheet is fine. Perfect is not required; started is.
• Calculate your debtor days. Divide outstanding sales invoices by annual sales, multiply by 365. Compare that with your stated terms — the gap is cash sitting with your clients.
• Chase on a schedule, not on a feeling. A named person, a fixed day each week, an escalation point.
• Invoice the day the work is done, not at month end. This alone can move debtor days by two weeks.
• Take deposits or stage payments on anything large or long.
• Shorten terms on new clients to 14 days. Existing clients are harder; new ones cost nothing to change.
• Check you are not paying suppliers early out of habit while you are chasing your own money.
• Put every tax date in the diary with the amount, as soon as it is known.
• Check drawings against profit quarterly, not annually.
• Hold a cash buffer target — a number of weeks of fixed costs — and treat it as a covenant, not an aspiration.

The questions to sit with

• Do you know what your bank balance will be in eight weeks? Within what margin?
• Out of 10, how comfortable are you chasing a client who is 30 days late — and what does that number cost you?
• If your largest client paid 30 days later than usual, would the business be fine?
• How much cash is currently sitting in work you have done and not yet invoiced?

Common questions

My accountant handles all this. Your accountant records what happened. A forecast is about what is going to happen, and it is a management job. The two are different tasks and only one of them prevents a problem.

How far ahead should I forecast? Thirteen weeks weekly for operations, twelve months monthly for planning. The weekly one is the one that prevents surprises.

Is an overdraft or invoice finance the answer? They buy time, at a cost, and they are worth having arranged before you need them. They do not fix a structural problem — if the cash gap is caused by pricing, terms or collection, borrowing simply funds it for longer.

What is a sensible cash buffer? It depends on how lumpy your income is and how fixed your costs are. Many owners work to somewhere between six and twelve weeks of fixed costs. Pick a number, write it down, and treat going below it as an event that requires action.

Profit keeps the score. Cash keeps the lights on. You need both, and cash is always the more urgent of the two.