Starting your own business

About us Business Structures Business Plans Business Finance Flexible Business Loans Small Business Marketing Start an Internet Business Home Based Business Company Formation Accounting and Bookkeeping Business Zone Business Dictionary
Latest News : Cross in Hand, Horam, Blackboys & Five Ashes - Sussex Express      Q&A: David English and Perry Coppen of the Vegan Supplement Store - Startups.co.uk      London is one of the top 15 cities in the UK to start a small business | London Business News - London Loves Business      Beard boom inspires Daniel to create a range of natural grooming products - Liverpool Business News      A Q&A with George Chalmers, founder of energy switching service Migrate - Startups.co.uk      

Profit versus Cash

 

Why is it that many businesses report large profits in their financial statements and yet at the same time, record small or negative cash balances in their bank accounts?

The answer lies in the manner in which profit is calculated by accountants as they adhere to the rules of accruals and prepayments as specified by their governing bodies.

Perhaps the most appropriate way to depict the difference between profit and cash is with a simple example. A business has the following transactions in its financial year ending 31 March:

Sales - 100,000 units sold for £10 each
Purchases - 120,000 units bought for £5 each
Staff wages - 4 salaried people costing a total of £15,000 per month
Electricity costs - approximately £2,000 per quarter paid in April, July, October and January
Premises rent - £ 5,000 per paid quarterly as above.

Profit Basis Cash Basis
Sales £1,000,000 Sales £1,000,000
Purchases (£600,000) Purchases (£600,000)
Closing Stock £100,000 Closing Stock N/A
Staff Wages (£180,000) Staff Wages (£180,000)
Electricity Costs (£7,333) Electricity Costs (£6,000)
Premises Rental (£18,333) Premises Rental (£15,000)
Profit as at 31 March £294,334 Cash as at 31 March £199.000

Difference = £294,334 less £199.000 = £95,334.

* 120,000 purchased less 100,000 sold

** Paid Bills in July, October and January. Owes February and March usage which will be paid in April after the year end. Therefore accounts reflect usage = £2,000 x 3 + (2/3 x 2,000) = £7,333 due for the year and £6,000 actually paid.

*** Rent paid is for the year in July, October and January was (£5000 x 3) £15,000, whereas as the months February and March have accrued (£5,000 x 2/3) = £3,333.

The above example highlights some of the differences in the way profit is calculated and how the ultimate figure may vary significantly from the amount of cash on hand.

The main discrepancies occur due to the following:

  • Stock. Items purchased but which have not been sold at the business’ financial year end is shown as stock. The value of this stock is deducted from purchases in order to show the true cost of the sales which were actually made.
  • Electricity and premises rent. Here the bills are paid in arrears and therefore in order to show a true profit, periods which have used the services but which remain to be paid are included when calculating a profit figure.
    This may well be different from the amounts that have actually been paid by the business.

As well as being profitable, a business must also be mindful of its cash position. For example, a business which invests its entire cash balance in stock which it is able to buy cheaply but which it will not sell for some months might fail simply because it has insufficient funds to pay other bills.

This is despite it having the potential of being very profitable in the longer term when it has finished selling the stock it bought at reduced prices.

 
Email This Page  Print This Page


 
 
Site Search
Take the 6 question quiz and test your knowledge on matters relating to starting your own business
1. Contribution is the difference between
 
Selling price and direct expenses
Turnover and net profit
Turnover and gross profit
Selling price and gross profit
  
Submit
 
Single Question Survey
Did you know that company formations can be carried out entirely online without any need for paper or written signatures?
 
Yes
No
  
Submit