Why profit may not equal cash in the bank

One of the most frequent questions I have been asked by owners of profitable businesses is “where is the cash?” They’ve been trading profitably for a long period but still have a large overdraft! Why?

Some timing differences are understood, expenses are generally incurred before the sales can be made. However there is often an additional lag because accounts record the sales invoiced and expenses incurred in a given period. That this measure of trading does not equate to cash movements can best be illustrated graphically.

A very simplified example shows Stable Ltd

  • Expenses e.g. stock, salary costs are paid for at the end of the month a sale is made
  • Sales invoices are issued at month-end with a strict 40 day credit period
  • The period begins with no cash in the bank

Stable Ltd is making a steady profit (green bars) as shown by the graph and table below:

Graph Income ,Expenses, Profit

 So – steady profits – no problem? Until we look at the cash flow as illustrated in the graph below:  

 

Stables’ cash flows are negative. The green bars show overdraft (negative cash) increasing then only gradually diminishing despite the (positive) profit. Stable raises and records the sales invoices on 31 January (£1,000) but does not receive the cash until early March. Meanwhile costs such as salaries and stock have to be paid in January.

Although not illustrated, despite having accumulated profits of £2,000, Stable does not have positive cash until September at which point the balance is £250.

It’s important then, to understand and model your cash timings. In the example above, if Stable had an overdraft limit of £750, despite trading profitably it would soon have faced difficulties.

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