It’s time for the annual meeting with your tax accountant and he has advised you of a fairly hefty tax bill as you made a pretty decent profit over the course of the financial year. If your first thought is to ask yourself how you are going to pay it then you wouldn’t be the first and will certainly not be the last. Unfortunately, many small business owners are unaware of the difference between profit and cash and so when it comes to the end of the year fail to understand how they could have made a profit but have no cash reserves.
The following will give you an idea of where some of this “missing” cash might be:
The main problem here is that too many people think that once the invoice has been sent to the customer, the sales process has finished. In another article we outline the value of ensuring that you have a robust credit control process to ensure you get paid for the work you do.
If your Trade Debtor value is increasing, the gap between your profit and cash balance will also increase. You have spent money in order to be able to deliver the goods or services to the customer and that cash, and the profit that goes with the deal is tied up in that invoice. A robust process to get cash in will allow you to ensure that Trade Debtor balances doesn’t become an issue. Monitor how long, on average, it takes to get paid by your customers and take the necessary steps to reduce it or if that is not possible, plan your business cash flows around those longer payment terms.
Conversely to Trade Debtors, a reducing Trade Creditor balance means that cash is leaving the business in order for you to pay those suppliers. In the early days of setting up and growing your business you will have found it difficult to have extended payment terms, you may even be paying up front, but the longer you trade with the supplier the more chance you have of getting more reasonable payment terms.
If, for example, you have to pay on 30 days from the date of the invoice and you pay on 15 you are giving yourself less time to get the cash in from the sale of the goods to offset the out flows. However, if you take advantage of the full terms you have been given, and stick to them as outlined in another blog post, you are reducing the period of time between payment and receipt from your customer, that you have to fund the business for.
Loans and other Finance payments
While these are payments that will have to be made on a regular basis, only the interest element tends to hit the Profit & Loss account. You may have purchased some plant and equipment in a prior year that was subject to the enhanced Instant Asset Write Off scheme and so took the full benefit against profit in that first year. However, if you have a finance lease agreement to pay for that asset over five years, you will be making cash payments with no corresponding impact to the P&L for depreciation.
Dividends and/or Drawings
As the business owner you are entitled to be paid for the work you do but you may not necessarily draw a wage in the same manner that your employees do. There are a number of options available to you but not all of them will have an impact in the Profit & Loss account in the year you pay them. You may decide that you will draw a full wage and be paid on a regular basis, which will reduce profit in line with cash. However, you may decide to pay yourself a minimal salary and then pay “drawings” or directors loans if the business is incorporated, to make up any shortfall you require to meet your personal obligations. Finally, you may decide to only pay yourself out of dividends, which are taken from after tax profits and won’t have an impact on current year profit numbers.
So, the next time you are confused as to where the profit has gone as you can’t see it reflected in the bank account balances, you may have a better idea where to start looking.