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.

Match your spending to the profit generated

In partnerships and LLPs (and in companies but to a lesser extent), partners tend to regard their earnings as the money they draw out of the business each month. This is quite understandable as it’s the money they live on, pay their mortgages with and invest for their future. In actual fact these drawings are advance payments on account of profit yet to be earned, so if you over-estimate your profit, you’re overdrawing against profits that simply aren’t there. In practice, firms estimate partners’ profit shares at the start of every financial year and the amounts they are then permitted to draw are matched accordingly. This is fine as long as the original estimate is right but if profits start to fall during the course of the year, monthly drawings should be scaled back too.

So how do you reliably link profit to cash?

We recommend including a cash flow statement in your monthly management accounts, and you could also include a cash flow forecast to keep you aware of upcoming cash flow peaks and troughs. Both are derived from your profit and loss and balance sheet reports and should interlink. This would help you see how your business’s profit translates into cash in the bank, so you can then exert influence over certain areas of the business to create a more direct link between an increase in profits and an increase in the bank balance. The most obvious of these is to bill clients as quickly as possible and urge them to pay you in accordance with the agreed credit terms. You should also review your drawings and dividends policies to ensure, as much as possible, that the cash being drawn out of the business’s bank account is proportionate to the expected profits generated.

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