Accounting 101: Cash & Profit

This article provides a primer on the difference between cash and profit. The concepts are related, but different, and getting them confused can be the difference between a high-growth, thriving business and one that is forever surprising ownership with a lack of the profitability that should accompany their hard work.

Cash: It’s the lifeblood of every business and is determined by the timing of the money flowing in and flowing out. Actively managing cash ensures your business can thrive today and in the future.

Profit: Profit is different from cash in that it is an accounting concept, and, when using the accrual method of accounting, ties revenues and expenses to when work is being performed, not when bills are paid. These timing issues associated with profit can be confusing in small business when a company may be paid for work that it has not yet performed, or perform work for which it has not yet been paid. If you collect deposits, for example, there may be some cash in the bank, but that is not yet “revenue” on the income statement. Or you may pay for materials and labour in one month, but not invoice it until the next month.

Confused? That’s because learning to talk accounting is learning a whole new language. Let’s take a closer look.

“How can we have money in the bank and be unprofitable?”

While it may come as a surprise, a business with lots of cash on hand can be unprofitable. Let’s look at an example. Bob the Builder checks his bank statement to find $100,000 after all outstanding cheques have been reconciled. He feels with this buffer, he is in a good position to hire a new project manager and move to a larger facility – both of which he has dreamed of for years.

Bob hires his PM and moves. He can now take on two projects at a time and the deposits are rolling in. The PM has a rocky start, but after a few long weeks of overtime, the customers are happy and the referrals are rolling in. After the dust settles, and he takes a couple more projects on, Bob finally gets around to meeting with his accountant, only to find out the past few months have been unprofitable. “Odd,” he thinks to himself. “Everyone has been so busy and we have lots of cash in the bank.” Despite the warning sign, Bob decides the best way to ramp up profit is by taking on a few more projects. He uses the same template he always has to estimate the projects and seems to be winning everything he bids. The next month, however, the accountant sounds the warning bell again. They are still losing money. Bob sits down with his wife to talk about the situation. “What the accountant is saying isn’t possible. We’re working harder than ever on more jobs than ever and we’ve got money in the bank. I think I should start looking for a new accountant.”

Many project-based businesses get into this sort of trouble. They see cash in the bank and assume they are profitable, especially when they were profitable previously. Oftentimes a business working in this mode will slowly see its profits (and cash balance) eroded until they are close to insolvency.

What Bob forgot is that his overhead had increased with the new facility and project manager. In addition, he’d been giving the hourly crew cost of living raises, but he hadn’t changed the charge out rate to his customers in his estimating template. On top of this, because there was cash in the bank from the project deposits, Bob assumed that would translate into profit. The end result was a shrinking margin and dwindling profits.

If a business doesn’t update its fees as time passes, it may even win more projects because the market recognizes a bargain. Unfortunately, while the firm is scrambling to meet deadlines because they have so much work, they aren’t making any money. The lesson is: Don’t let cash fool you! If you aren’t making a good margin on a per-project basis, it is time to re-examine your business model or increase your fees.

Cash is King

Your current cash position is almost never the balance in your bank account. We see so many owners checking the daily balance, sometimes obsessively, and yet getting blindsided by sudden changes. So, if cash position doesn’t mean the bank balance, then what is it? Cash position is the total funds your business has to spend AFTER all outgoing, incoming and recurring payments are made in a given period. Let’s look at an example:

Bob has $10,000 in his chequing account, but this is not his real cash position.

Bob has written 10 cheques in the last month, two of which have not been cashed:

• Cheque #00051: $2,000 to his PM for salary
• Cheque #00054: $5,000 to a sub-contractor for electrical work

Additionally, a new customer just dropped off a deposit cheque which Bob will cash today for $4,000.

In this case, Bob’s cash position is not $10,000 and trouble arises when Bob believes he can write a cheque for $9,000 for rent. He writes the cheque, and it gets cashed two days later. Unfortunately, in the time between Bob writing his rent cheque and it getting cashed, The PM and sub-contractor cash their outstanding cheques. Bob’s cheque for $9,000 bounces. He loses credibility with his landlord, can’t write cheques for other payments, and is potentially insolvent (cannot pay his obligations) without an injection of cash, to which he may or may not have access.

What was Bob’s real cash position?

If Bob had understood what his real cash position was, he would never have cut the $9,000 cheque, and it wouldn’t have bounced either.

In summary, your real cash position is the cash you have on hand (bank accounts, petty cash, customer cheques), the cash that is easily accessible (credit or lines of credit) minus your obligations (outstanding cheques, recurring payments, cash payment to a temporary employee etc.).

Why is understanding your cash flow is crucial to success?

1. You know how much actual money your business has on hand. If Bob knew he couldn’t write that $9,000 cheque, he could have waited to get more funds, paid the landlord over several periods or asked for credit terms.
2. Knowing your cash position forces to you understand the inflows and outflows of cash. Simply put, being aware of your cash position means you must also be aware of what has been paid but not cashed, what money you are due and what you are obliged to pay in the coming periods. This is vital information to any business, and understanding your cash flow lets you manage your finances appropriately and sleep better at night.
3. It acts as one part of a road map to future success. Understanding future cash flow is vital to planning expansion, understanding when to hire and knowing when to use credit to your advantage.

Understand the difference between cash and profit. Profit is an accounting concept that is not impacted by the timing of when bills are actually paid. Cash, however, is the real money on hand that can be used to finance daily business transaction. Don’t confuse the two concepts, and you will be on the road to financial success.

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