Cashflow and Profit
Profit is the amount of money your business makes over a set time, usually one year, less the expenses for the same period. It is measured using a Profit and Loss Statement. Cashflow is a different thing. It is possible to have a really good profit but no money in the bank. Four reasons for this are:
1. Cashflow is about when money is received
Cashflow looks at when money comes in and out of your business over a period of time. Cash flows into the business from sales, and out of the business as it pays suppliers, wages, and so on. The idea behind a healthy cashflow is to always have enough money to cover your bills. It is about having enough money to keep the business going from day to day, week to week, and month to month.
In comparison, profit looks at the total amount of sales revenue for the year, less the total cost of goods sold and the total expenses. It does not matter when the sales or the expenses actually happen.
Example 1: Timing of Cash Received
Consider the example of a software business which works all year to develop a complicated product for a customer. It may be agreed that the customer will pay them $1 million once the product is finished and handed over. If the total cost of goods sold and expenses are $600,000, they will make a profit of $400,000. However, the business will need to figure out where they will get the cash to be able to pay its employees while they are making the product. If there is not already $400,000 in the bank, they will have a cashflow problem.
Example 2: Timing of Expenses Paid
At the end of the year, a business received a bill from a supplier for $1,000 for work they had carried out. This $1,000 would be counted as an expense for the year, even if the business had not yet paid the bill. In this case, there is money still in the bank, but the profit is lower.
2. Not all cash flows are ‘expenses’
There are a lot of things your business may have to spend money on. For example, you might need to pay courier costs and wages, buy inventory to sell, and pay to get a website designed. If you are a sole trader or partner, you may even need to take drawings out of the business for personal use, and if you have a business loan, you will need to make payments on this. All of this will take cash out of your bank account, affecting your cashflow. However, not all of these items are considered to be ‘expenses’.
Some reasons for this are:
- Inventory is only counted as an expense when it is sold. In the meantime, the amount of inventory sitting in your shop or warehouse is counted as an ‘asset’ to the business.
- Items a business buys which cost $500 or more and have a useful life of more than a year are assets, not expenses. Common examples of assets are websites, furniture, and computers.
- Drawings are not counted as a business expense. This means the business’s profit is likely to be higher than the cash left in the bank. In comparison, if someone is an employee of their business, their wages are counted as an expense.
- A loan is not an expense. Instead, it is a ‘liability’ (debt) which you are paying off.
3. Not all expenses affect cashflow
Sometimes expenses do not require you to make a payment. The most common examples for small businesses include depreciation and bad debts.
Depreciation refers to spreading the cost of buying an asset over the years it is expected to be of use in a business. In other words, depreciation involves treating part of the cost of an asset as an expense each year until the asset is no longer useful. Any business assets which cost $500 or more and have a useful life of more than a year are depreciated. A bad debt is when you ‘write off’ money owed to you from customers.
If a business pays $2,000 for a piece of equipment which has an expected useful life of two years, $1,000 may be ‘expensed’ each year. This means that there will be an expense of $1,000 shown in the second year, even though the equipment was paid for in the first year.
Example: Bad Debts
If you do work for a customer and send them a bill of $800, that $800 would be included in your profit. However, if after a period of time it becomes clear that you are not likely to receive payment from the customer, this $800 needs to be ‘written off’. It is counted as an expense, even though no money will come out of your bank account.
4. Cashflow includes GST
If you are registered for GST, your Profit and Loss Statement will not show any GST at all. However, GST will flow into and out of your bank account. At the end of the year, you may have GST owing which you have not yet paid, meaning there is GST sitting in your bank account, but not in your profit figure.
You need to consider both your cashflow and profitability when making business decisions. Some options for improving your profitability may negatively affect your cashflow in the short term, and vice versa. For example, if you decide to invest in new equipment or a marketing campaign to increase your sales, make sure you will have enough cash in the bank to pay for this and keep operating in the meantime!