Cash and profit: a performance over a period and a position on one day
Definition
Profit: revenue minus total costs, measured over a period of time such as a month or a year.
Cash: the money a business actually holds in its bank account and its till at this moment.
- Profit is worked out by taking every cost of the period away from the revenue earned in that period, so it is a figure you calculate rather than one you can count.
- Cash is the balance sitting in the account today, which a bank statement will show you to the penny.
- Profit is a measure of performance and cash is a measure of position, so profit tells the owner whether trading is worthwhile while cash tells the owner whether Friday's wages can be paid.
- The two are recorded at different moments, which is why a business can report a healthy profit for the month and still have nothing in the bank.
Why the two figures pull apart: four timing mechanisms
- Profit is recorded when a sale is made or a cost is incurred, while cash moves only when money changes hands, and four everyday situations separate those two dates.
- Credit sales: a sale counts as revenue when the goods leave the premises, but the cash may not arrive for 30 or 60 days, so the profit is recorded well before the money is received.
- Credit purchases: a business can receive stock now and pay for it later, so the cash leaves after the cost has already been counted, which flatters the bank balance for a few weeks.
- Stock: money spent on unsold stock has gone out of the bank but is not yet a cost against profit, because it counts as a cost only once the item is sold.
- Large one-off payments: buying a van or paying a tax bill to HMRC takes cash out without being a normal running cost of that month, so cash drops much further than profit does.
Note
- Tracking these timing gaps month by month is the job of a cash-flow forecast.
- Net cash flow and the opening and closing balances are covered in the guides on cash-flow forecasts.
Profitable with an empty bank account: the case that catches owners out
- A firm sells £20,000 of goods in a month that cost it £14,000, so it has made £6,000 of profit.
- Its customers pay 60 days later, but it must pay its own suppliers and its staff this month.
- The firm therefore has £6,000 of profit and no cash, and if the rent falls due it cannot pay.
- An unpaid landlord or supplier can demand payment or refuse to supply again, which means a business whose trading is genuinely profitable can be forced to stop before the £20,000 ever reaches its account.
Example
- Greggs sells cheap hot food over the counter on the high street, so the customer pays at the moment the sausage roll is handed over.
- Revenue and cash arrive together, which keeps the profit figure and the bank balance close to each other.
- A bakery that instead supplies offices and cafes and invoices them at the end of the month earns the same revenue but waits weeks for the money.
- Same product and same profit, but a very different cash position, because what changes is who pays and when.
The reverse case: plenty of cash while making a loss
- The gap runs the other way too: money from a new loan or from selling a piece of equipment lands in the bank without being revenue, so a business can hold plenty of cash while making a loss.
- A healthy bank balance is not proof of a healthy business, because that money arrives once while the losses repeat every month.
- A business narrows the gap by collecting from customers sooner, paying suppliers later, holding less stock or arranging an overdraft, which is covered in 1.3.4a.
Exam technique
- Answer a cash and profit question by naming the timing gap, not by repeating the two definitions.
- Build the chain: the sale is made in March, the cash arrives in May, the wages fall due in April, so the business is short in April.
- If the case study mentions credit customers, a large stock order or a new vehicle, that is the examiner pointing at the cash gap.
- Never write that a profitable business must have money in the bank, because that one line gives away the mark the question is testing.
Self review
- State one difference between what profit measures and what cash measures.
- A firm sells £20,000 of goods in a month that cost it £14,000, so what profit has it made?
- Why does a credit sale raise profit before it raises cash?
- Why does money spent on unsold stock reduce cash but not profit?
- Why can a business hold plenty of cash while it is making a loss?
