BridgePoint Group’s Neil Parker gives us some insights and explains the difference between cash and profit. Certain things you spend money on don’t go to your P&L…
Firstly let’s adopt a definition of cash and profit.
Profit is a marker of the overall prosperity of a business in a given period such as a month, quarter or financial year. As most of you will already appreciate, you find that number in your profit and loss (P&L).
While cash is what keeps the company’s wheels greased and running in its day to day operations. You probably also know that you can find your cash balance on the balance sheet.
So when we say cash isn’t the same thing as profit, you might already have surmised that we’re talking about things that are in the P&L but don’t have a contemporaneous impact on cash, or things that do impact cash but are not in the P&L.
With us so far? If not, then maybe this example will help.
What happens if you buy a new asset and pay cash for it?
The cash is gone from your bank account but it does not (immediately) affect your profitability. The asset lands on your balance sheet, not in your P&L as an expense. Cash at bank is also listed on your balance sheet. So, both sides of that transaction (the debit and the credit), the whole impact is on your balance sheet. Your fixed (or non-current) assets have increased (i.e. plant & equipment), whilst cash at bank has decreased. So, the asset purchase is purely on your balance sheet and hasn’t touched your P&L yet but does affect your cash balance.
When does it touch the P&L?
From an accounting perspective, when you depreciate an asset, the depreciation appears on your P&L. It may be depreciated over five or ten years. Over that five to ten year period, the depreciation impacts your P&L.
To provide an example, let’s say you’ve spent $100k on a piece of equipment and are depreciating it over ten years. Each year over the next ten years, $10,000 will hit your P&L. On day zero (the day you purchased the asset) $100,000 of cash went out of the business. You depreciate the asset over ten years because you know in ten years’ time you are going to have to buy another one. Depreciation is an accounting entry designed to record the diminution of the value of that asset over time. You’ve spent money but it hasn’t impacted your P&L immediately. There is an obvious disconnect between cash and profitability in this example.
On the flip side, for each of the next ten years, whilst $10,000 is hitting your P&L, therefore reducing your profit, the cash outflow happened on day zero. This is another example of a disconnect between profit and cash.
There are many more examples. But the point of this discussion is not to be exhaustive but to help you to understand why cash and profit are not the same thing and to focus you on the things that truly matter. As a business owner, it’s your responsibility to know these things. If you don’t know them already, then do something about it. Ask me, ask your accountant. Whatever works. But doing nothing is dangerous.
OK, sermon over. But here’s a few more things to consider.
The wider impact of using cash to purchase an asset
Consider that you’ve just spent the $100k, not knowing there’s a raft of expenses about to hit and there’s no cash to cover the outgoing expenses. That spells trouble. Businesses fail when they run out of cash, sometimes even if that’s only a temporary state. As we’ve consistently noted, that’s why the saying goes “cash is king”.
When you have expended cash on an asset that is expected to generate a future business benefit, you have created a vulnerability, a risk that you will need that cash to meet immediate needs but you no longer have it. And this is why it sometimes makes sense to finance that asset – to match your cash outflows against the benefits (cash inflows) you expect to receive. (Of course, the materialisation of the expected benefits is also not certain, so that’s another class of risk).
Cash and Profit, if looked at in isolation, may not send the right messages.
Many people manage their business based on what their cash balance is. There’s a couple of problems with that. Number one, you know what’s just happened, but not what’s about to happen. It’s like driving a car, just looking at the bumper of the bus in front. Far better if you can see a hundred metres ahead.
Number two, you need to keep an eye on profitability because that’s going to tell you whether you’re getting ahead. Profit is what’s going to turn up in cash in the fullness of time. Running a business just by ‘cash balance’ is not providing a complete financial picture. You need to be mindful of your balance sheet, cash flow and P&L.
Cash Flow and Cash Resources
Cash flow is how long does it take a dollar to leave your bank account and then show up again. Typically, cash flow looks a lot like this:
- An input is purchased
- A product is manufactured with that input
- The product is held in inventory until it is sold
- A sale is made and credit terms are offered
- Payment is ultimately received
The period between ‘cash out and cash in’ will be dependent on any number of factors. All seemingly working as forces slowing down the cash hitting your bank!
Cash resources for a business focuses on how much cash is flowing in the business at any given time.
Is there a million dollars tied up in the business or 5 million dollars tied up in the business? You may have your cash flow optimised to turn over as quickly as you can make it turnover in the industry you trade in. Often the problem is not the flow, it’s that you may have insufficient cash to operate effectively in the first place.
Cash and Growth
If your business grows, you will need more cash to grow. You will need to buy more inventory, pay more wages, pay more rent etc. Sometimes you don’t have enough cash in the system to facilitate that growth. Look at it like the blood flowing in your body. Compare the amount of blood a child requires to survive versus an adult. It’s like cash. If you don’t have enough blood (cash) then you are cactus.
Cash (or lack of it) is the greatest source of stress for the business owner and has an inverse relationship. The more cash, the less stress. Conversely, when cash is causing a business owner to stress, they’re likely to need a simplified way to think about the next steps to grow your cash resources.
Other ways to ease a cash burden..but watch for pitfalls
You can look at deferring expenses. How do you do that? Easy but what of the short, middle and long term implications.
Say you defer marketing expenses as it is a discretionary spend.
What is the impact?
When the phone stops ringing or the website enquiries dry up, then what do you do?
Are you prepared to wear the hit in six or twelve months from now? Marketing that has proven to have strengthened your brand is an investment.
Look at training. Spending money on training, which is an investment in your people. Can you cut training costs? Yes. Should you? Arguably no.
These actions will have an impact.
Maybe you can wear the impact but the real question is should you?
They can be risks you’re putting into the business. Is it an absolutely necessary one? If you are looking at a cost-cutting exercise, have a think about the costs you are cutting. Some expenses that may impact on cash levels and the P&L I would argue must be viewed as investments. Whatever cost-cutting decisions you make, think about what may happen in the longer term as a result of that decision.
Ultimately the success or failure of your decision will come down to how you execute that decision.
If you need to discuss effective cash management or you would like to better understand the trinity that is your P&L, balance sheet and cash flow, then reach out to the BridgePoint Group team and see how we can help you.
Contact via 1300 or email us at email@example.com