What is the difference between profit and cash?
Cash and profit are two important elements of any business. Cash is measured by the cash position and cash flow statement, whereas profits are displayed in the company’s profit and loss (P&L) statements.
Business owners often face the dilemma as to whether they should focus on cash generation or maximising profits. Without understanding the difference between cash and profit and how focusing on one over the other could impact your business, the affects could be detrimental to your business growth and longevity. For example, it is easy to offer sales promotions to generate fast cash by sales, but this may end up damaging long term profit.
So, one way to understand the difference between cash and profit is to look at how different financial elements within a business impact either. Here are some examples:
- VAT – affects your cash balance, but not your profit.
- Loan repayments – affects your cash balance but not your profit.
- Interest on loans – affects both your profit and your cash balance.
- Asset purchases – only affects your cash balance.
- Asset sales – affects your cash balance. Asset sales in conjunction with depreciation also affects your profit.
- Depreciation – only affects your profit.
As you can see, even if your business achieved a healthy profit, there may not be any cash in the bank after paying tax, making loan repayments, and buying new assets. The wheel starts with the business owners they need to invest money into the business.
This money can then be used to purchase any assets that are needed to run the business. The business may need additional funding to buy all the assets required, so a loan may be required.
These assets are then used to generate a profit. Profits can be increased by growing your sales or margins, but overhead expenses can drain your profit and result in a loss if they’re not managed.
The profit then gets turned into cash. Drains on your cash include slow collection of debtors, high inventory days, loan repayments, tax repayments and payments to suppliers. A business can achieve cash gains by collecting their debtors faster, decreasing their inventory days and negotiating longer payment terms with suppliers.
The owners then take cash out of the business as drawings or personal loan repayments. The remaining cash can then be re-invested into the business to purchase more assets to generate more income.
The aim is to go through the cycle as quickly as possible to increase your return on investment (ROI). The faster the wheel spins the more your ROI increases!
Business owners often ask us “Why if I am profitable, can I not take money out of my business?” and as explained above, it’s all because of the way these two interact, how they are managed and how financial reports are created.
Understanding the difference between profit and cash, what impacts them and how they can be managed is essential for business profitability and long-term success.
So, now you’re clued up on our topic what’s your knowledge like when it comes to your financial reports such as your Statement of Profit & Loss (P&L) and your Balance Sheet?
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