Most businesses start with one thing in mind. ‘How much profit will it make?’ OR ‘How much money will ‘I’ as a business owner will make?’ Although there is nothing wrong with having a set target and having profit as the main driver for making decisions. Profit can often be manipulated, and therefore what a business started out to achieve can somewhat become vague.
So let me rephrase; what businesses actually want when they started out is: Cash Or Money! Without money, no business can function. But hang on a sec! Isn’t having profit the same thing as having cash?
Sorry to break it to you, but they are two totally different ideas, or shall I say two different sides of the same coin?!
Put simply, profit is the leftover income after deducting business expenses. However, there is more to it.
Accountants follow something called a matching principle. This means expenses are recognised and recorded in the period in which related revenues are earned, regardless of when they were paid. Let me explain.
Let’s assume a business had promised its operational manager a 5% bonus at the end of the year. The operational manager has hit his targets and is now owed his bonus. As the bonus was yearly, it was calculated after the year-end, and therefore the manager will be paid at the start of the new accounting year. Even though the manager will be paid in the new accounting year, the 5% bonus will be recorded in the year it was promised.
Profits this year will be less, although your cash will be more. However, next year your cash will be reduced, which can cause quite a bit of confusion.
This shows exactly how profits can show a slightly distorted image.
Cash is what makes the business operational. For a business to pay its expenses it is an absolute must that there is sufficient cash available.
If a business fails to have enough cash available, it will have to resort to borrowing via debt or equity, or even think of shutting doors.
Therefore, it’s a must that a business has a robust cash flow system in place, as it would show the true picture of how much cash is available at any given time.
Compared to profit, a cash flow will only record when an actual transaction takes place; i.e. when the manager was physically transferred his 5% bonus.
Most often managers get targets based on profits. This makes it extremely difficult to keep a congruent relationship between the needs of the shareholder and managers of the business.
Managers will try everything to show the profits as healthy as possible, and this could mean making short-term decisions at the detriment of long-term goals.
Following are just some of the ways that profits can be manipulated, which owners of the business should be aware of:
- Provisions: This could be in a form of a bad debt which could be reduced for the current year to show a higher profit.
- Cut off: Some invoices could have been deliberately left out from the current year to keep the expenses low.
- Misclassification of revenue items and capital items: Capital items such as purchases of assets (fridge, printer, computer etc) are included in the balance sheet, and only a small amount in the form of depreciation is taken off the P&L. To keep the expenses low some revenue (general expenses such as stationery, books, etc) items can be misclassified as capital item to keep a healthy profit.
Even though the profit and loss is a great way to see how the business is performing, and provides a medium through which targets can be measured, profit and loss statement is open to manipulation.
Further a profit and loss statement goes through various adjustments, which does not provide a true image of how much cash is available. It is advisable – especially for small businesses owners – to keep a cash flow forecast, so that they are aware of their cash position at any given time. Having a cash flow forecast in place will give you peace of mind that you not only have enough cash to pay off business expenses but it will also provide you with insights if the actual cash is not reflecting the forecasted cash flow.
To give your business the best chance to thrive, contact us to find out how we can help in providing you with regular cash flows for your business.