It is important when running a business to fully understand that there is a huge difference in practical day-to-day terms between profit and cash. This is because a profit is recognised as having been made when your overall income for the business exceeds expenditure (i.e. outgoings). All of this is as determined by accountants following one of the key cornerstones that they must adhere to when preparing a company’s annual accounts. This cornerstone (the accruals principle) relates to the fact that income is recognised when it is earned (e.g. the date when an invoice is issued to a client) and not when the cash has been received (e.g. when you actually receive the money in your bank account), which could be many months later. Likewise expenditure is recognised when it is incurred (e.g. when you have received an invoice from a supplier), not when the money has physically been transferred from your bank account to theirs.
As such, following the accruals principle it is easy to begin to see that a company can be showing a strong result in terms of profit, but at the same time may not actually have that much money in their bank account. Let’s say you are a small business with only a handful of larger customers. You may have £5k in cash sitting in your bank account, and this morning you may have issued one of your clients with an invoice for £25k. As profit is recognised when it is earned, that £25k is now appearing on your Profit & Loss Account (The Income Statement), but you haven’t received the actual cash as yet. If you now (the same day) receive an invoice from a supplier for £10k, that item goes onto your Profit & Loss Account as expenditure (therefore reducing your profit), but irrespective of what is occurring in relation to your profitability, in practical terms you don’t have enough funds to pay that supplier their £10k until such time as your customer has paid you.
So, all of this potentially becomes problematic when those owing you money are taking their time to pay you, but conversely those to whom you owe money are applying pressure to get paid from you. Matters can very quickly begin to get highly pressurised as you find that you are not sitting with enough cash to pay other suppliers, vehicle fuel, staff salaries etc. All of this because you are waiting for some large invoice to eventually turn into physical cash in your bank account.
It is therefore paramount that you do a number of things to protect your profitable business from having a cashflow crisis. Namely: cashflow monitoring; chasing invoices promptly; agreeing preferential terms with suppliers; resisting the temptation of over-trading … In any business cash is king – ALWAYS. The well coined saying that, ‘Turnover is vanity; profit is sanity and cash is reality’ is so very true.
