Why profit does not equal cash

What is the difference between profits and cash? There is quite a big difference, and it can be a huge difference if you are a capital-intensive business or project-based business.

Cash relates to actual funds moving in and out of bank accounts. Profit is total sales minus total expenses, calculated on paper even if money hasn't changed hands yet.

There are several main drivers of the difference between profit and cash:

1.   Timing. A good example of this is annual business insurance: you receive the invoice for the whole year and you pay the invoice in one go, shortly after the invoice is received, but your accountant won’t recognise it as a cost in one month - they will spread the cost in the profit and loss account over the year.

2.   Assets. When you buy a fixed asset the cash goes out straightaway, but the cost of the asset will be recognised in the profit and loss account as depreciation over several years.

3.   Taxes. VAT is the main culprit - it isn’t recognised in the profit and loss account because it isn’t the organisation’s money, it belongs to HMRC. The cash for VAT on sales and costs goes through the bank account, and the tax bill gets paid, but none of this is reflected in profits.

4.   Credit terms. You give your clients time to pay and your suppliers give you payment terms too. The invoices are usually recognised in the profit and loss account as soon as they are received, but the cash doesn’t move until days or weeks later.

5.   Stock and WIP. The cost of making something is only reflected in the profit and loss account when it is sold. You can have lots of money tied up in stock and WIP which will generate profits in the future, once the sale has taken place.

A good accountant should be able to explain these differences in simple terms and help you understand. They should also be able to provide good cashflow statements that reconcile the difference between profits and cash, as well as cashflow projections that give you clear visibility on what will be happening in the bank account in the future.

A good Finance Director will help you understand how these differences affect your business, help you maximise cash to support the financial resilience if your organisation, and ensure that financial governance and strategy support the development of your business.