Cash v Profit – Why lawyers must understand the impact for clients
One in four businesses fail in the first year; and over a half don’t get past 5 years due to poor cash flow management.
So why does such an everyday concept of managing cash have such a significant impact on a business’ ability to make a profit and in many cases survive and, what’s more, why does a lawyer need to understand how their clients are affected?
To help to understand why managing cash is key to your clients’ successful business continuity read Matt’s story and how his actions to generate and improve sales had an adverse impact on his ability to survive.
Cash versus profits – Matt’s story
Matt is going to have a difficult day today. It is the middle of August 2015 and he is due to meet his bank relationship manager to see if he can arrange a temporary overdraft facility.
It all started when Holly, a university friend, described a gap in the market to him for a particular type of retail product (call it “the Tingle”) that she has designed and is now starting to manufacture.. Matt is immediately taken with the product and eventually agrees to make an initial purchase of 4000 Tingles at 80p each.
Holly requires cash on delivery. At the start of July 2X15 Matt sets up a distribution business called MattEnts, opens a bank account and deposits £6,000 of his own money to start the business going.
Matt has two other chums, Alice and Mesut, who have each set up their own retail businesses and, like Matt, are taken with the Tingle and agree in early July to take 1,200 and 400 items respectively at a price of £1.10p.
Very soon afterwards, and after some tricky negotiations, Matt signs up a corporate retail chain, Drainbead plc, who will take the remaining 2,400 Tingles at £1 per item. Their terms of business are for all suppliers to give them 30 days credit.
July was quite a good month.. However, a look at his online bank statements shows that he is burning through his £6,000. Cash of £1,760 has come in from Alice and Mesut, but he has had to pay Holly £3,200 and pay £300 for delivery and packaging.
This leaves him with a balance of £4,260 from which he decides to draw £250 to cover some of his personal living expenses. Matt is greatly comforted by the fact that Drainbead will be paying him £2,400 in the next few days.
The first Monday of August Matt takes a call from the buyer at Drainbead. Great news! The Tingle is selling incredibly well and would like to buy a further 5000 items. These are to be delivered to Drainbead outlets as soon as possible.
A call to Holly reveals that she will have 5000 Tingles ready to ship in the next few days but will still require payment in cash. The Drainbead buyer is delighted that the order can be fulfilled. Matt duly pays Holly £4,000, receives the 5,000 tingles and starts to deliver them to various Drainbead outlets in the second week of August.
Drainbead still have not as yet paid Matt for the first delivery. He calls the Drainbead buyer who transfers the call to the accounts department who inform him that his invoice was too late to be processed for their August supplier payment run and will now have to wait until September.
Matt e-mailed the invoices for both the July and August orders as soon as the Tingles were delivered to the Drainbead outlets. Apparently the buyer was late in submitting the July invoice to accounts for approval and payment. Meanwhile Matt is also due to pay £300 for August delivery charges.
It is now the middle of August and Matt has burned through almost all of his £6,000 and must now try to negotiate some credit with the bank.
A familiar tale?
Sadly yes – one of big customers pushing small suppliers to the edge. In the short term Matt will (a) need to use his interpersonal skills to secure the sympathy and understanding of his bank relationship manager and (b) aggressively chase Drainbead for the amounts owing, otherwise he will be unable to continue to trade.
How do MattEnts’ accounts report cash and profits?
Accountancy has many little quirk’s and paradoxes one of which is that profitable trading can lead to bankruptcy. So far in relating Matt’s tale we have focussed on how much cash is flowing in and out of his bank account in July and August 2015 and, as we have seen, it is not a pretty picture.
The paradox is that in both July and August his Statement of Profit or Loss (PorL) prepared by his accountant will report a reasonable and growing business profit!
But, as Matt has painfully discovered, earning a profit in July and August does not mean there is the same amount of cash coming in to his bank account over the same period. Why should this be?
The answer lies in the accounting practice of reporting income and expenses in the PorL of the period to which they relate rather than when they are received into or paid out of cash. In the case of MattEnts this means that revenue is reported in the PorL when the delivery of the goods is made and Matt has the right to sue for his money (ie in July and August) rather than when the cash is received. This explains why his PorL reports net profits whilst his bank account falls into the red.
Some concluding thoughts
MattEnts profits or losses for a period are reported in a Statement of Profit or Loss and his cash inflows and outflows in a Cash Flow Statement.– Which of these key financial statements do you think Matt should pay most attention to?
Well, unless you make sales you have no chance of making a profit and a cash surplus. However if you cannot collect your cash you cannot continue to trade. So the answer is BOTH!
To be financially successful a business must manage both its profits and cash flows and be acutely sensitive to the differences between them especially when agreeing terms of business with customers and suppliers.
Associate News is provided by Legal Futures Associates.
Find out about becoming an Associate