There is a saying in the accounting world that states ‘turnover is vanity, profit is sanity and cash is king’.
One of the common misconceptions we see our clients grapple with is the idea that the cash they currently hold in their bank account is pure profit, or, conversely, why their accounts show their business is profitable, yet they are suffering from a shortage of cash flow.
It would be entirely forgivable to believe that a company that shows a healthy profit has an abundance of cash reserves in the bank. However, this misconception is often made because people have failed to acknowledge the delay between showing profit and actually receiving the payment.
What is profit?
To illustrate this point, first, we need to define what ‘profit’ actually means. In the context of accounting, ‘profit’ can be described as ‘a financial reflection of the operational activities that occur during a financial period’
If we dissect this phrase a little, we can say that ‘operational activities’ are the things we do in the day-to-day running of the business. For a creative business, this would include selling your creative services, paying your staff or freelancers, and perhaps buying some new equipment or software.
The financial period is simply a predefined amount of time, often a month or a year in the context of a business.
The ‘financial reflection’ is how these day-to-day activities affect your balance sheet in that period of time (the financial period).
How are cash and profit different?
Where profit can be illustrated on a profit and loss sheet as a number, cash on the other hand is something you can actually remove from your business bank account. Cash is a physical item you can hold, count and spend.
So why does cash in the bank not necessarily equate to profit (and vice versa)? It’s all to do with the flow of income and expenditure into your bank account and the time frames and delays associated with this.
As an example, your company sells a ‘service’, producing a video for a client. You may quote them £10,000, to which they agree. You might then send a commencement fee invoice of £5,000, and you’ve just made a sale.
This sale will then be registered in your profit and loss account and will impact these figures positively (i.e. + £10,000), but crucially, the actual transfer of funds (the cash) will not be transferred into your bank account for 30 or 60 days (as per the terms of your invoice). Even then it is not the full £10,000 but rather a deposit of £5,000. So while the ‘sale’ positively impacts the profit and loss account immediately, the cash will not be there for some time.
This also works in reverse. If we buy services into our business, we won’t necessarily pay for these straight away, rather we pay the invoice in 30 or 60 days. Therefore the total amount of cash sat in your account is not all profit when you consider you will need it to pay for a service in a month’s time.
Because profit (from the sale of services or goods) is recorded on an accrual basis, (meaning when sales are made), and not when you receive the money it shows as profit before you receive the cash.
Expenses are recorded when they are incurred (i.e. when you receive and process the invoice, not when you pay it). Accrual accounting is widely used and relied upon as the most accurate form of accounting, compared to cash accounting. Accrual accounting is matching business transactions to the period in which they relate, regardless if cash has flowed in or out.
Cash flow matters…
For this reason, it is important for a business to understand its profit and loss statements and be mindful of its cash flow because even a business that is profitable can still face huge difficulties if its cash flow dries up.
At AO Accountants we help creative businesses, such as production companies, digital agencies and branding consultants with all accounting and bookkeeping services.
If you’re a creative business looking to work with an accountancy firm that understands your business, then get in touch with us to find out more…