The simple answer is that profit does not equal cash.  In fact profitable businesses run out of cash and as a result go out of business regularly.

So where is the cash then?

To understand this you need a lesson in how profit is calculated.

The Accruals concept

A transaction is recorded at the time it takes place irrespective of whether money changes hands or not.  You make a sale to your customer and immediately raise an invoice but your customer may not pay you until anywhere between one and three months after this.  You make a purchase from your supplier and receive an invoice on that date but you take advantage of his credit terms paying him thirty days later.

The Matching concept

Revenue is matched with the expenses that generated it.  For example your businesses insurance will normally give you cover for a twelve month period but this may not coincide with the businesses financial year.  It may, for example, start half way so only half of the cost will be relevant to the year.  Electricity is usually billed on a quarterly basis and the quarter may start two months before the businesses year end and end one month after.  To match this expense with the revenue it generated two thirds of it will need to be included in the accounts for the financial year just ended.  The timeline below illustrates this diagrammatically.

Accruals concept timeline

The Prudence concept

Liabilities are always taken into account at the earliest point.  Your accountant will include a provision in the accounts for his fees even though you may not get the bill until six months after the year end he is preparing.

Other factors causing a disparity between profit and cash

An increase in sales will increase profit but if your customers are taking longer to pay this will have an adverse effect on your bank balance.  The purchase of a vehicle will have an almost immediate effect on your bank balance even if you are only paying the deposit but the effect on the profit will probably be spread over four or more years via depreciation.  You may have decided to stop selling a particular line and, as the stock gradually reduces, so your bank balance may gradually increase, all other things being equal.

Cash shortage solutions

If you find your business is regularly running short of cash there are ways of countering this and this is not necessarily by increasing overdrafts or taking out loans.  The first thing you should do is to monitor your cash-flow on a daily basis, that way you will begin to see if there is a pattern of cash-flow highs and lows and from there you can find out the causes.  For example, are your sales seasonal and as a result you need larger stock-holdings just before the busy periods? Could you work with your suppliers to bring down the stock levels by obtaining shorter lead in times?  Will your suppliers give you extended credit terms at the time you need to build up your stocks?  Are your customers taking longer to pay or not paying at all?  If so you will need to beef up your debt collection facilities.  In addition you should never grant credit facilities to new customers before you have checked their credit rating.  You could also insist on payment up front for the first few orders.

As you can see there are things you can do without resorting to additional borrowing.

Need help with your cashflow? Call The Really Wicked Accountant.