Have you ever asked yourself this question? If you have, you aren’t alone. Many business owners use the one universal financial metric that they know and understand – The Bank Balance. However, come tax time (when your accountant prepares a set of financial statements), you might notice that there is quite a difference between your profit and bank balance. In a lot of cases, the profit is a lot higher than the bank balance. Let’s see why.
We’ll start with how profit is calculated, which is simply the income minus the expenses. So, if you made $600,000 worth of sales revenue and incurred $390,000 of expenses, you are left with $210,000 profit. Now, what if part of the $600,000 of sales has not been paid yet? Let’s say you still have $50,000 owing in outstanding debtors. This is classed as income on your Profit & Loss Statement (P&L) yet it still isn’t showing on your bank statement. On the other hand, let’s say you received a bill from a supplier on 30 June and you haven’t paid it yet. This would be classed as an expense (reducing your profit) and would sit as an amount owing (a creditor) even though it hasn’t yet been deducted from your bank account.
Another reason for variances could be if you purchased any fixed assets during the year (such as a motor vehicle, plant & equipment or office furniture). Fixed assets are not classed as an expense and will not go on your P&L, but the amount will still be deducted from your bank account if the items were paid for in cash. Also, if you take any drawings or loans from your business, it will not classed as an expense and it will not reduce your profit, but it definitely will reduce your bank balance! If an investor lent your business some funds, this would be classed as a loan (or a purchase of equity) and will not affect your P&L but it will obviously place funds into your bank account.
The goal is not to have your profit equal your bank balance, but a conversation, at least annually, with your accountant to determine why these amounts are different, will identify areas where cash is being tied up and may result in some quick wins to improve your cashflow.
The thought I would like to leave you with is that it is risky to run your business using your bank balance as your compass. As you are now aware, there are many other factors at play (and many, many more) which can be very deceiving and has caught many business owners out.
The most successful businesses I work with have a concise and actionable Business Plan and a Cashflow Forecast for the next 12 months. These, I believe, are the cornerstone services required for business development.
To discuss your business cashflow and look at cash improvement opportunities, simply contact our office.