We often have business owners approach us saying that they are working hard, doing all the right things but feel like they aren’t making any money. Their existing advisors keep telling them that they’re making a profit, but despite looking everywhere they can’t seem to find these hidden profits. The real crunch comes at tax time when they have a tax bill but no cash to pay it.

If you use computerized systems for your bookwork a Profit and Loss Statement (P&L) is a great report to run, however these don’t always tell the whole story.

Firstly, it’s important to note whether the report you’re running is on a ‘cash’ or ‘accruals’ basis. Most software defaults to accruals – what’s the difference?

The difference between Accruals Basis and Cash Basis

Accruals Basis shows you the full picture. It includes invoices you’ve raised that you haven’t received the cash for, and bills you’ve received that you still need to pay.

Cash Basis shows you the situation based on what has actually been paid and received. While it’s handy to track your cashflow, if you’ve finished a job that you paid out expenses for, but haven’t received the money from the customer yet, a “Cash” report will skew the results.

tip: If you sell services or time, make sure you run job-costing to ensure profitability.

Your profit is hiding in your balance sheet

Many business owners gauge their business performance based on their bank account – if there’s money in the bank then business is good. When they then look at their P&L they expect a similar profit to what’s in the bank. But as said before, the P&L only tells half the story. You need to also look at your Balance Sheet (BS).

In accounting, not everything lands on your P&L. Items that are considered ‘capital’ instead go to your Balance Sheet. This means as you pay for these items they don’t reduce your profit, instead they increase your assets or reduce your liabilities.

Business loans: if you’ve received finance from the bank to start your business, buy equipment or purchase vehicles your repayments go to the Balance Sheet to reduce the loans. It’s only the interest portion that hits the P&L and is deductible.
Drawings: If you don’t pay yourself through payroll (i.e. you just draw money as you go) these payments also go to the balance sheet and not the P&L. Often this method leaves a business short of cash as too much money can be drawn to support personal lifestyle. If you run your business through a company or trust structure this can also cause some tax issues down the track. A better way is to ensure you separate your business and personal expenses and draw a set amount from the business and make your lifestyle fit this amount.
Equipment Purchases: Similar to loan repayments, when you purchase equipment for your business the purchase goes to the Balance Sheet not the Profit and Loss – so you might think you are reducing your taxable income by buying a big ticket piece of machinery, however only a fraction of this is deductible in the first year through depreciation.
Inventory Purchases: These sit in an asset account until the item is sold, it is only then that the deduction for the purchase moves to the P&L as a Cost of Goods Sold.

So if your profit is real, but locked up in your balance sheet how can you release it and turn it into cash that can be used in your business?

If you are a retailer or sell a product and you hold inventory to meet orders, well this is a big pile of potential cash that’s sitting in your business. This is fine if you turn over stock quickly or hold minimal stock, however if you’ve got items in your storehouse that have been there for ages then you need to move them. If you thought you were onto a winning product but sales have been slow you need to make the decision to either up your marketing actions to move the stock at the original desired price or consider reducing the price to a point where the market will purchase. The deduction for what you’ve spent on inventory won’t make it to the P&L until the item is sold or written off.

Similarly, if you’re serviced based you are likely to have Work in Progress (WIP). These are effectively banked hours of work you’ve done but haven’t billed your customer for. To release the cash out of the balance sheet you want to focus on the total time it takes from start of job to when you bill it to the customer. You may also want to consider progress billing for larger jobs or even deposits upfront.

How to release cash hiding in your balance sheet?

Release cash hiding in your balance sheet by moving inventory and invoicing WIP quicker.

However the cash won’t flow if people take a long time to pay you even after you’ve made the sale. If you have Accounts Receivable in your assets list this is cash that isn’t in your bank account. To get it into your account you want your customer to pay you more quickly than what they currently do. The first step is to work out how many days it takes them to pay right now (Debtor Days) – we use a dashboard to track this that updates daily and automatically so we can see how the number of days change over time. Next explore what actions you can take to influence your customers paying time – this could include:

Reminders to pay before the debt is due
Providing multiple payment methods – we find ‘pay now’ with online payment makes a huge difference
Debtor process that includes what action is taken where, including stop work option
How your business assesses new customers and provides credit – do they start on COD and earn payment terms?

*learn more on getting paid quicker here

As you implement each step, watch how your Debtor Days fall – this is money coming into your bank account quicker.

Our dashboard currently shows our debtor days at 13.2 – we offer 14 day accounts, so this means that ALL our clients are currently adhering to our credit terms. The industry average for accountants is 55 days with 14 day terms – so these changes and monitoring our customers makes a huge difference to our cash flow compared to others in our industry.

To summarise:

Not everything is shown in your P&L; you need to look at your Balance Sheet too
Capital purchases (equipment, stock) don’t go directly to the P&L
Only the interest portion of loan repayments go to the P&L
Making sales, moving stock and getting customers to pay you quicker will release the profit that’s in your balance sheet and convert it into cash flow.