CFO & Advisory

Cash vs profit: why your bank balance lies to you

A profitable business can run out of money and a loss-making one can be flush. Neither number is lying; they are answering different questions.

An owner looks at a healthy bank balance in October and hires two people. In April the tax bill arrives, the balance is gone, and the profit and loss says the business made money all along. Another owner sees the account drop by $30,000 in a month and cancels a marketing campaign; the drop was a stock order that will sell over the next quarter at a good margin. Both decisions came from reading one number as if it meant the other.

What profit measures

Revenue earned minus costs incurred in the period, whether or not the cash has moved. An invoice raised in March is March revenue even if it is paid in May. A year's insurance paid in January is spread over twelve months. Equipment bought for $10,000 is expensed over its useful life, not on the day it is bought. Profit is a measure of what the business is worth doing.

What cash measures

Money in minus money out. It includes things profit ignores (loan principal, owner draws, equipment purchases, inventory purchases, tax payments, deposits received) and excludes things profit includes (invoices not yet paid, bills not yet paid, depreciation). Cash is a measure of whether the business can pay Friday's payroll.

Where the gap comes from

ItemEffect on profitEffect on cash
Invoice raised, unpaidRevenue upNone yet
Customer prepays a yearOne month of revenueFull amount in
Stock purchaseNone until soldFull amount out
Equipment purchaseDepreciation onlyFull amount out
Loan receivedNoneIn
Loan repaymentInterest portion onlyFull payment out
Owner draw or distributionNoneOut
Income tax paymentNone (or below the line)Out
Sales tax collectedNoneIn, then out

Reading the cash flow statement

The third financial statement reconciles the two. It starts from profit, adds back non-cash charges (depreciation), adjusts for working capital (receivables, payables, inventory, deferred revenue), and then shows investing (equipment) and financing (loans, owner money) separately. A business whose operating cash flow is consistently below its profit is either growing fast (receivables and inventory absorbing cash) or collecting badly. The statement says which.

The four common traps

  1. Tax money treated as available. Income tax, payroll tax and sales tax collected all sit in the same account as operating cash. A separate tax account, funded monthly, removes the April surprise.
  2. Growth eating cash. Every extra month of sales on 45-day terms is a month of costs paid before the cash arrives. Profitable growth needs funding; the 13-week forecast shows how much.
  3. Draws exceeding profit. Owners who take what is in the account, rather than a set amount from profit, hollow the business out invisibly, because draws never appear on the profit and loss.
  4. Capital purchases mistaken for expenses. The reverse trap: the bank falls, profit does not, the owner panics about a business that is fine.

The monthly check

Put last month's profit next to the change in cash. Explain the difference in five lines or fewer: receivables moved by this much, inventory by that, loans, draws, tax, capex. If it can be explained, both numbers are trustworthy. If it cannot, something is unreconciled. This five-line reconciliation is on the first page of every management pack we send.

The check you can run today: this month's profit, minus the change in your bank balance. Write down what the difference is made of. Whatever you cannot name is the thing to look at.

Questions this raises

Which should I manage the business by?

Both, for different decisions. Pricing, hiring and product decisions from profit and margin; timing decisions and survival from cash. The mistake is using one for the other's job.

Why does my accountant say I owe tax when there is no money?

Because tax follows profit, and the profit was spent on stock, equipment, loan repayment or draws, none of which reduce taxable income. The tax account funded monthly is the fix.

Is this what a virtual CFO does?

A large part of it: a monthly pack that reconciles profit to cash, a rolling cash forecast, and a conversation about what the gap means for the next decision.

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