Is My Money Profit or Cash--How Can I Tell the Difference?

 

“My Profit & Loss report shows I made a profit, so where’s my money?!” I hear this question often from new clients. While it seems logical to think that profits mean cash in the bank, it’s actually a misconception that is held by many. Let's work through this and discuss why this misconception exists.

We’ll start by taking a look at your P&L (Profit and Loss Statement or Income Statement). On your P&L you will see your Net Income (or Net Profit). This is the money you have left from sales after you pay for your products minus expenses. Many business owners equate this to cash in the bank.

However, to get an accurate picture of your cash, you need to also review your Balance Sheet, which is a summary of your business across time, not simply information for the current year. I recommend pulling the Balance Sheet from the last business date for the prior year. For example, for businesses operating on a calendar year, December 31, 2018 would be the last business day for that year. Then pull the Balance Sheet for the current year to date and compare the bank balances between the two reports. Have your balances increased or decreased? For example’s sake, we'll assume your cash increased. That should be your profits, right? Well, not quite.

You must now factor in your liabilities, or what you owe, such as loans and credit card debt. To get a better understanding of the state of your liabilities, go through the same steps as you did with the Balance Sheet comparison. Do you owe more or less than last year? Let’s assume you owe less now than at the end of the prior year.

Next, I want you to compare the difference between your cash and your liabilities. What we hope you see is that your cash increased and your liabilities decreased. It indicates that some of that bottom-line money went to pay down debt. Another scenario is that your cash and your liabilities both increased. This means your cash increased, and you're using credit cards or loans to pay for expenses. The final scenario is that your cash decreased and yet your debt increased. In this case, your P&L may be showing a negative bottom line, indicating that your business is suffering and you need to get your income and/or expenses under control. 

Finally, you need to examine the Equity section of your Balance Sheet. You most likely have accounts for Owner or Partner Contribution and Distributions. When you compare these accounts from last year-end to the current date, does it show that your money increased or decreased? Depending on the structure of your business, your pay may show up on the Balance Sheet as an Owner Distribution rather than on the P&L statement. If your P&L bottom line is $60,000 this year to date and you've paid yourself $70,000 so far this year, your cash will go down accordingly.

Oftentimes when I perform a Profit First Assessment, tracking how the cash flows in a business, I see people using the cash to pay themselves and using credit cards or loans to pay their operating expenses. This is not a sustainable business model and must be improved in order to be sustainable long term.

Below is a quick example of how you can use your report to show where your money is going. In this example, the business is using the modified cash accounting method, meaning that inventory is recorded as an asset on the Balance Sheet until it is sold. Once the products are sold, an entry is made to reduce the inventory account and record the COGS on the P&L. This information is important to know in order to develop strong financial health for your business. 

Example

The P&L shows the net income for the current year-to-date is $15,520.

The Balance Sheet shows the end of the prior year for the client, and data for the current year-to-date. In the calculations below, the first figures are the current year-to-date, and the second figures are the end-of-prior-year. 

 

Quick Calculations

Bank Accounts: $18,753 - $30,826 = $-12,073; the bank account decreased

Liability Accounts: $8,420 - $4,341 = $4,079

Owner Contributions: $43,767 - $30,467 = $13,300

Owner Distributions: $105,234 - $56,493 = $48,441

Net of Owner Contributions and Distributions: $48,441 - $13,300 = $35,141 cash reduction to the business

 

Analysis

According to the P&L Statement, the current year-to-date profit is $15,520, meaning the business did generate cash. Looking at the Balance Sheet, we can see the cash in bank accounts has decreased while the liabilities have increased. This is usually an indication that the business is not profitable. The Equity section shows that the owner has taken $35,141 out of the business this year to date. The cash generated from the business is insufficient for meeting the owner’s cash demands, and in turn, the debt has increased to meet the need. This approach is not sustainable long-term, and the business needs to find other ways to meet those cash needs. Implementing the Profit First method for cash flow turns this entire scenario around and allows for monies to be allocated to the various business accounts on a regular basis so there are no surprises or deficits when it comes time to pay expenses, employees or yourself.