Profit is not cash

Profit is an accounting measure: income earned in a period, less the costs of earning it. Cash is what is in the bank. The two move together over a long enough time, but in any one year they can be far apart. The businesses most likely to show the gap are the ones a financier sees most: growing, trading on credit, and holding stock.

Where profit and cash part company

A sale counts towards profit when it is invoiced, not when it is paid. So does the cost of the goods sold. Meanwhile, cash goes out to buy stock before anything is sold, and comes in only when the customer pays. In between sit three balances:

• Debtors: sales made but not yet paid for. Profit has been counted; cash hasn’t arrived.
• Stock: goods paid for, or owed for, but not yet sold. Cash may have gone; no profit has been counted.
• Creditors: costs incurred but not yet paid. This works the other way, and helps cash.

Together these make up working capital. When working capital grows, it absorbs cash, even though nothing appears as a cost in the profit and loss account.

A worked example

Ashdown Fixings Ltd sells fixings to builders’ merchants on 60-day terms. To keep the example simple, ignore VAT, depreciation, tax and dividends. Last year it had sales of £1,200,000. This year it won two new customers, and sales rose by half, to £1,800,000. It made a net profit of £90,000.

Its working capital at each year end:

	Last year (£)	This year (£)	Change (£)
Debtors	200,000	300,000	+100,000
Stock	100,000	150,000	+50,000
Creditors	70,000	105,000	−35,000
Working capital	230,000	345,000	+115,000

The business needed £115,000 more working capital to support the higher sales. It made £90,000 of profit. So its cash went down by £25,000 in its best year yet.

Nothing in that is a warning sign on its own. Every growing business that sells on credit faces the same arithmetic. It becomes a problem when the growth is faster than the funding, which is called overtrading. Look for:

• the overdraft at its limit, and HMRC paid late;
• suppliers paid later and later, so creditor days stretch;
• requests to fund invoices early, or before goods have gone;
• profit still reported every month, so the owners don’t see why money is tight.

Where receivables finance fits

This is the gap an invoice finance facility exists to fill. The facility grows with the sales ledger. If Ashdown’s facility pays an 85% prepayment, the extra £100,000 of debtors could release up to £85,000 of extra funding, as long as those debtors are approved and eligible. That turns a £25,000 cash shortfall into £60,000 of headroom.

That is the good case. The same arithmetic tells you what to watch:

• Debtor days. If customers start paying in 90 days rather than 60, the debtors balance grows faster than sales. Some of it may become ineligible, just when the client needs funding most.
• Stock. Your facility funds debtors, not stock. A business whose stock is growing faster than its sales is building a cash need the facility will not cover.
• Concentration. Two new customers driving half the growth means two debtors you need to understand well.

Other ways cash leaves without touching profit

Working capital is the biggest gap, but not the only one. Buying equipment or vehicles takes cash at once, while profit is charged only a year’s depreciation at a time. Repaying a loan, paying dividends and lending money to a director all take cash and leave profit untouched. A cash flow statement shows each of these. In management accounts you may have to work them out from the movement in the balance sheet.

Reading it in the accounts

The filed accounts will rarely say any of this outright. Put two balance sheets side by side and work out the movement in debtors, stock and creditors yourself. Compare the total with the year’s profit. If working capital grew by more than the business earned, ask how the difference was funded: a bigger overdraft, a new loan, a director putting money in, or suppliers and HMRC waiting longer. Each answer tells you something different about the year ahead.

Questions for the next review

• Is profit turning into cash, or into debtors and stock?
• How much working capital will the next year’s growth need, and who is funding it?
• Are creditor days stretching to make up the difference?
• What would happen to cash if the biggest customer paid 30 days late?

Profit tells you whether a business is worth funding. Cash tells you whether it will still be there to fund. A financier needs to read both, and to know which one the client is talking about.