Profits and cash – they are not always the same thing
Profits and Cash – more profit does not necessarily mean your bank balance will be higher…
Where have my profits gone? This is a question we are regularly asked by clients. Usually, the conversation is triggered when we discuss their end of year accounts. Profits and cash are not the same things.
Before we explain why profits are not always represented by cash in the bank, we need to define what the term “profits” actually means.
Basically, “profits”is the price of what you sell less the costs associated with making those sales and all your other business expenses. If you are VAT registered, any VAT element is excluded from both figures whereas if you are not VAT registered then you can ignore VAT altogether.
Consider Jeremy, who is not VAT registered and runs a small shop selling widgets. He started his businesses by introducing £5,000 of his own money and at the end of his first trading year his summarised results were as follows:-
- Sales £80,000
- Goods purchased in the year £60,000
- Other costs paid for in the year £15,000
- Stock at end of year valued at cost £7,000
- Drawings for personal use £16,000
- Bank balance = overdrawn £6,000
He had been paid for all his sales and had paid out for all his costs in the year.
His accounts will show profits of £12,000 (This is made up of sales of £80,000, less cost of goods sold of £53,000 (£60,000 less the unsold stock of £7000) and less other costs £15,000.
So why, Jeremy asks, is his bank account overdrawn by £6000?
The answer is that by the end of the year Jeremy had withdrawn £16,000 for his own private use and had purchased £7,000 of stock that was unsold at the end of the year. We also need to consider that Jeremy had introduced £5,000 of his own cash when the business started.
The reconciliation of his profit and the bank balance is therefore: Profit for the year £12,000, less personal drawings £16,000, less unsold stock at year end of £7,000, plus initial capital he introduced of £5,000, equals minus £6,000– his business bank overdrawn balance.
This would of course have been complicated further if he had not paid for all his purchases by year end (he had creditors) or had not been paid for all his sales (he had debtors) as his closing bank balance would have been higher by the amount he hadn’t paid and lower by the amount he was owed.
We can deduce from this explanation that to reconcile profit and cash in the bank isn’t always easy as your Debtors and Creditors will need to be considered in addition to the value of any unsold stock. Personal monies that you put in or draw out are also discounted when calculating your profits.
But perhaps best just to ask your Accountant to explain it to you at your end of year review!
If you need help with your Cashflow or any other financial related matter please get in touch – we’ll be happy to assist.
About Mark Boulter
Mark Boulter is responsible for the efficient running of the firm’s infrastructure, and ensuring that THP delivers the best client service. Promoting the vision and culture across all branches, people are the key: “I like people who have a fresh approach and I’m happy for them to run with their ideas,” he says.
Communication across departments is crucial and Mark pioneers this. He ensure that people and departments not only talk to each other, but that they share ideas– whether they’re about marketing, finance, sales, strategy or any other topic that can result in us offering a better service. “I think helping to develop the next generation of THP people is essential to our success,” Mark adds. “We’ve a lot of talented people and our way of doing things increasingly attracts ambitious newcomers who are looking for a fresh approach. That’s good for us and even better news for our clients.”