Profit is not the same as money in the bank

“The year ended with a profit, but there’s no money in the account.” We hear this from business owners often. Both numbers can be correct, because profit and money are not the same thing. The income statement shows whether the company earned money; cash flow shows whether it has anything to pay with.

In our survey only 28% of business owners could say for sure how many months the company could keep going without new sales, and 30% would not know where to find the money if an unexpected cost came up (read the survey summary).

Why profit and money go separate ways

The client hasn’t paid yet

A sale is recognised as income when the invoice is issued. If the payment term is 30 or 60 days, the profit is in the report but the money is still on its way. The faster sales grow, the more money is held by clients.

The money is in the warehouse

Purchased goods and materials only become an expense once they are sold or used. Until then, the money is tied up in inventory and you do not see it in the income statement.

Loan principal is not an expense

Only loan interest appears as an expense in the income statement. Repaying the principal reduces cash but not profit, so a month with a big loan payment can be profitable and still negative in cash terms.

An investment is spread over several years

When you buy equipment or a car, you often pay the full amount at once, but only part of it reaches the income statement each year as depreciation.

VAT and prepayments

VAT is neither income nor an expense for the company, but it passes through the bank account. If that money is spent before the tax payment date, paying the tax comes as a surprise. The same applies to prepayments made to suppliers.

Payments to the owner

Dividends and other payments to the owner don’t reduce profit, but they do reduce cash. If they are made without looking at cash flow, a profitable company may end up paying its bills late.

A simple example

Let’s say a company sells 60,000 euros’ worth in a quarter and its costs are 50,000 euros. The profit is 10,000 euros. At the same time, customers still owe 20,000 euros, 8,000 euros of new stock was bought for the warehouse and loan principal repayments were 3,000 euros. The income statement shows a profit of 10,000 euros, yet at the end of the quarter there is actually 21,000 euros less in the bank than at the start of the quarter. (The example is illustrative.)

Two stories from our clients

Puus Investments: bank transactions recorded correctly and automatically

Seeing your cash flow starts with bank transactions being recorded correctly and on time. Uuno Puus values an approach where the automatic features of the accounting software are used to the full, above all the import of entries. That way, bank transactions reach the accounts quickly and correctly.

I like your approach that it makes sense to use the automatic posting features built into accounting systems (I mean above all the import of entries).

Uuno Puus, member of the management board, Puus Investments OÜ

LasoN Entertainment: knowledge that stays in the company

For Marcus Paju, it has been important that his questions always get an answer and that through our cooperation he has learned to better understand how to manage the company and account for costs.

I have gained so much good knowledge and skills for managing my company better and for accounting for costs.

Marcus Paju, member of the management board, OÜ LasoN Entertainment

How to see profit and money at the same time

• Check three numbers together every month: profit, cash in the bank and clients’ unpaid invoices.
• Make a 3–6 month cash flow forecast. Include salaries, taxes, loan payments and bigger purchases. You can prepare it with the help of a part-time CFO.
• Track incoming payments. Late invoices are the most common reason why a profitable company ends up waiting for money.
• Plan your payouts. Before a dividend or a big investment, check how it will affect your cash reserve over the coming months.

Monthly financial controlling puts profit, cash flow and key metrics on one page. To get bank transactions into the accounts automatically, use our software and integrationsservice. If you want to learn to read financial statements yourself, take a look at the KL Financial Academy.

The three parts of the cash flow statement

The cash flow statement shows where the money came from and where it went. It has three parts:

• Cash flows from operating activities: payments from clients, payments to suppliers, salaries and taxes. This is the most important part, as it shows whether the core business brings in money.
• Cash flows from investing activities: purchases and sales of equipment, vehicles and other fixed assets, and investments made.
• Cash flows from financing activities: loans, their repayments, leases and dividends.

If operating cash flow is constantly negative while the income statement shows a profit, it is a clear sign that money is tied up in client debts, inventory or prepayments.

Month-end checklist

1. How much money is in the account today and how much is needed for next month’s obligations?
2. How much do clients owe and how much of it is overdue?
3. How much money is tied up in inventory and prepayments?
4. Which bigger payments are coming up: taxes, loan payments, leases, annual fees?
5. Is the cash flow forecast for the next three months still positive?

If you can’t find the answers within five minutes, this is where financial controlling can help.

Frequently asked questions

Summary

Profit shows whether the business is healthy. Cash shows whether the company will get through next month. A good manager watches both, because a profitable company can run into trouble precisely when it is growing fastest.