Why Your Business Has No Cash But Makes a Profit

cashflow business concept with money fall or falling from above with team peopl

Identify Common Causes of Cash Flow Issues

Business accounts can be prepared in one of two ways. The first method of accounting is known as cash accounting, which means that transactions are only recorded in the books when money changes hands. If you are using the cash accounting method, your accounts will mirror movements in cash. So, it will be relatively easy to see where your money has gone.

However, most business accounts are prepared under the accruals accounting convention. This method provides a more accurate picture of the business for a given period because it recognizes and matches income and expenses when earned or incurred. For example, sales are recorded when the sales invoice is raised. Purchases are recorded when the vendor’s invoice is received. Income and expenditure are matched by way of adjustment journals like accruals, prepayments, and depreciation.

So, the accruals basis gives you a much better idea of how the business performs month by month. However, this method of accounting can also mask cash flow problems. Your business could, for example, be making monthly profits. But, at the same time, you could always be struggling to pay the bills.

You can see where the cash is going by preparing a cash flow analysis of your balance sheet. However, it will also help you identify and avoid potential problems if you understand the common causes of cash flow issues in a profitable company. So, here are ten reasons why your business might be short of cash even when making a profit.

1. Errors in the Accounts

The first port of call if things aren’t quite making sense is to make sure that your books are in order. For example, are the accounts right up to date?  Do the books balance? Are crucial reconciliations such as the bank reconciliation being completed? And is inventory being periodically checked? If you have significant concerns about the accuracy of your accounts, it would be best to hire an accountant to review your books.

2. Theft or Fraud

Unfortunately, theft or fraud might be at the heart of your cash flow problem. Theft could be occurring in terms of cash stolen from petty cash or fraudulent transactions on your bank account. Stock may also be swiped from your inventory. Suspicion of theft or fraud would be another reason to get an independent accountant to review your books.

3. Failing to Collect Accounts Receivable

The reason why you are short of cash might be that you need to tighten up on your credit control procedures. Indeed, lax credit control procedures can leave a significant hole in the cash flow. So, review your aged accounts receivable to see how much overdue debt you are carrying. If there are many accounts with balances in the 30-days plus past-due column, you need to spend more time on collections or hire someone to chase overdue accounts.

4. Paying Vendors Too Quickly

On the other hand, it might be that you are paying vendors too quickly. So, take a look at your aged payables to check that you are taking advantage of the credit you have been granted. Paying suppliers as soon as an invoice is received will indeed simplify managing payments, and prompt payment will prevent you from receiving any collection calls. However, it might be better to make use of all the credit vendors grant you so you can keep the cash in the bank for longer.

5. Holding Too Much Inventory

When you use the accruals basis, the cost of inventory only hits the profit and loss account when the product is sold. So, your stock levels could be high, your cash flow tight, but you could still show a healthy profit.

The best way to avoid cash being tied up in inventory is to monitor your inventory turnover rate. This ratio will help you identify if you are holding stock for too long. A healthy turnover ratio will indicate that you turn over inventory every one to two months. Much more than that, and you probably have too much cash tied up in stock.

6. Overtrading

A rapidly expanding business can suffer from what is known as overtrading. In this scenario, you will be showing increasing profits but be experiencing ever-worsening cash flow shortages.

Overtrading occurs when a company has insufficient working capital to support business growth. In essence, the cash generated from the last period’s sales is not adequate to cover the purchases required to meet the increased sales of the following period. In such a scenario, an injection of new capital may be needed to cope with the growth, or the brakes will need to be applied to the expansion.

7. Overburdened With Loans

When you are carrying loans, the interest on the loans will hit the profit and loss account monthly. However, the capital repayments will be deducted from the creditor balance in the balance sheet and not affect profit. So, large loan repayments can drain cash but not put much of a dent in the monthly profit and loss figures.

8. Investing in Capital Items

When you purchase a fixed asset under the accruals accounting convention, the cost of the item is capitalized as a fixed asset. The acquisition is then depreciated over its useful life. But, if you bought the item outright, the cash for the purchase will impact the cash flow immediately. The way to avoid this potentially significant mismatch between cash flow and profits is to rent or lease-hire things like premises and equipment.

9. Plowing Too Much Money Into R&D

Your accountant may also be capitalizing research and development (R&D) costs. For example, if you are developing a new product, it would be correct under the accruals principle to hold the costs of that work until the product generates sales. But of course, you would still be paying cash for the development work. So this, too, would create a difference between cash flow and accounting profit.

Capitalizing R&D costs makes sense for large organizations that are confident of the success of ongoing projects. Big pharmaceutical companies, for example, will initially capitalize the cost of developing new drugs. However, it would probably be more prudent for small businesses to write off R&D costs as they are incurred.

10. Significant Work In Progress

The accruals basis dictates that costs associated with a long-term contract be capitalized as work in progress (WIP) until the project is completed and billed. So, those costs will not be immediately reflected in the profit and loss account. Or, in the event of stage payments, a proportion of the accumulated costs might be charged to the profit and loss account when part of the project’s revenue is recognized.

Sometimes called work in process, WIP can cause a time lag between items being paid for and the costs hitting the profit and loss account. And, this accounting treatment is usually used for large-scale projects, such as construction. So, businesses that take on long-term projects of this nature may likely require additional working capital or financing to cover these deferred costs.

The Bottom Line

Not all of the above points will apply to every business. And, as you can see from the above, many things can create a difference between profits and cash in the bank. But hopefully, this information will provide some pointers to where the difference between cash flow and profits might lie.

The essential point to recognize is that only reviewing the profit and loss account each month can be misleading. You must also maintain a cash flow forecast and look at any significant movements in the balance sheet to keep tight control of the liquidity of a business.

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