Surely if profits are rising, our bank balance should too. Yet so often businesses tell us the lines on the graph are on two completely different trajectories. Claire Watkins explains why we need to look at the relationship between profit and cash to understand why.

Most businesses record their financial results in a profit and loss account which, thanks to UK accounting convention, is not drawn up on a cash-in-cash-out basis. Instead, “profit” is a product of net income earned rather than cash generated. To link your profit to the impact it has on your bank account, you have to understand how profit is created in the first place and how it’s retained and used in a business:

Various factors influence the creation of profit and some of them have nothing to do with cash

It’s easy to see how profit is linked to the fees we bill to clients and the payments we make to employees and suppliers but some expenditure does not involve the transfer of money and some cash outflows do not affect profit. For example, most businesses make a charge against profit for the estimated depreciation of fixed assets such as IT equipment, fixtures and fittings. This reduces profit but has no impact on your bank balance. Conversely, partners and shareholders take money out of the business by way of drawings and dividends but neither of these affects profit.

Businesses generate profit but the cash inflow usually follows later

Every professional practice is familiar with work-in-progress: the idea that you attribute a value to the work you’re doing even though you haven’t billed it. Your accounting software records this as profit earned but your bank balance shows no increase because the client hasn’t been billed and therefore hasn’t paid you. In fact, your bank balance may even fall because you’re paying staff and consultants to do the work (plus expenditure on travel and incidental expenses) which you will bill on to the client weeks or even months later.

Profit needs unlocking

In an ideal world, we would bill our clients every month, they would pay us immediately and we would then have the money available in our bank accounts to draw out and spend. In the real world we tend to create profit which remains locked up – in cash terms – in WIP and trade debtors for many months. Meanwhile, we continue to spend money on business expenditure and draw money out for ourselves by way of monthly drawings and dividends. In a business generating turnover of £3m where the average trade debtor balance is £650,000, that’s 79 days’ worth of profit “locked up” and unavailable in cash terms. If we were to persuade our clients to pay us 20 days earlier than usual, it would increase our bank balance by £13,000 per day.