If you're a small business owner, contractor or self-employed and are having trouble managing your finances, this blog post is for you. It's a common mistake to focus on increasing profit without also considering how it impacts cash flow. You might find that the best way to increase cash flow is not by trying to make more money but by spending less of it.

It can be hard to know where in your business expenses you can cut back so we've created this guide with some ideas about where you could start. We hope that this helps!

What is the difference between cash flow and profit?

Cash flow and profit are two very different things – as a business owner, you can find yourself without the cash to pay bills despite making profitable sales. You may also be surprised to discover that strong cash flow from sales can deliver very little profit.

What is cash flow?

Cash flow is simply a measurement of cash moving in and out of a business. Therefore an accurate cash flow forecast prepared by your bookkeeper is vital in order to help you make the right decisions, such as when to buy assets or when to prepare for cash shortfalls.

The importance of cash flow

Cash flow is essential to the survival of your business – more so than profit especially in the short term. Profit is essential eventually but cash in the bank is needed to pay the bills.

For example, if you have good cash reserves, you can survive until your business becomes profitable. However, if your business runs out of cash, you will need to find a solution quickly to avoid problems.

What is profit?

Profit is the money left in your business after all your expenses have been paid. A profit and loss account reveals what profit your business made last month or last quarter. Your profit is detailed in two figures, namely:

Gross profit

What’s left from sales after deducting the costs of goods sold or services provided.

Net profit

What’s left from gross profit after all the other costs have been deducted.

The significance of profit

All businesses need profit to grow. Your profit can be allocated to (among other purposes):

• Investing in the company e.g. buying assets.
• Developing new products, new services, or intellectual property.
• Marketing, advertising etc
• Reducing debt levels.
• Paying dividends to shareholders.
  

Why can cash flow and profit differ?

The gap between a cash flow forecast and a profit and loss account reflects the different ways businesses receive cash from sales and pay suppliers.

Cash flow forecasts record cash

A cash flow forecast only records actual cash transactions. Cash flow can be boosted by inputs other than sales, such as:

• Capital injections by the owner or investors.
• Cash coming in from loans.
• Cash from selling an asset.

These sources increase cash levels to fund your business, they but aren’t profit.

Profit and loss statements show actual profit

Unlike the cash flow forecast, the profit and loss account includes costs that don’t involve cash outlays e.g. depreciation, bad debts etc.

Explaining discrepancies – so where has the money gone?

“The income statement shows a £50,000 profit, but the cash in the bank is only a fraction of this. The figures don’t match up. Where’s the missing money?”

A common example that can raise this question is a business that buys equipment for £40,000.

• The cash flow shows the £40,000 cash payment
• On the profit and loss account, the business will claim only the depreciation amount on a capital asset. However, the profit and loss account shows £4,000 as an expense against sales. This makes the business’s net profit seem much higher than the actual cash available in the bank.

Sales are great, so we must be making money?

“We’ve been extremely busy these past few months. Sales are booming – but where is the profit?”

It is easy to confuse ‘being busy’ with being profitable, but there’s a very clear distinction between the two.

If you haven’t calculated your selling prices correctly, your ‘thriving’ business may in fact be operating at a loss. The cash flow may seem great, but the profit and loss account will eventually reveal the true picture.

The critical lesson is to never set your prices until you know all the costs involved. You might end up operating at a loss or at an unsustainably small profit level.

We’ve made many profitable sales but can’t pay our bills

It’s quite possible to run out of cash or go bankrupt by taking on too much business too quickly, even though each sale is profitable. This is known as overtrading – and businesses that sell on credit terms are inherently more at risk.

Reasons businesses can run out of cash include:

• Purchasing too much stock
• Taking on more debt that the business can service
• Buying assets at inappropriate times
• Paying suppliers too soon. If suppliers offer 30 days, it makes sense to take advantage of the full credit period
• Customers taking too long to pay there invoices

Cash flow is all about timing

Cash flow is all about timing. If you pay expenses on day 1 and your customers pay you on day 30, then you need to fund the cash flow gap of 30 days. If your business is poor at collecting aged receivables you will use up all of your cash paying suppliers while waiting to collect amounts owed.

Make sure you have enforceable terms and conditions, and don't be afraid to enforce them.

As ever if you have any queries then please get in touch.