Posted: Wed 14th Jul 2021
As experienced finance directors and professional trainers, we meet a lot of business owners – and many of them come to us with some common questions.
Over the years, we’ve noticed three key issues that people tend to struggle with when it comes to understanding business finance and accounting.
Cash and profit are NOT the same thing
Understanding the difference between cash and profit can be hard for many business owners to get their heads around – but it’s important to know how they differ and why the difference matters.
First, some statistics...
Of the six million or so limited companies registered in the UK, approximately half will no longer be trading in five years’ time. You might assume this will be due to a lack of profit, but four out of five will actually stop trading because they’ve run out of cash.
It’s possible to trade at a loss and keep your business going, as long as you’re able to fund the business from somewhere – for many SMEs, this means injecting their own money to stay afloat.
It’s all about the timing
One of the primary reasons that cash and profit are different is to do with timing – for example, when you declare profit and when you receive/pay cash out.
Working capital – how much money you need to sustain your business from day to day – how much money you’ve received from your customers, versus how much you’ve paid out to suppliers and other ongoing running costs (overheads) plus what you have tied up in stocks and customers that have yet to pay you.
Declaring profit is triggered by invoice dates. Most businesses use credit terms, so from an accounting perspective, you declare the revenue and profit from the invoice date, but you may not receive the money for another 30 days, or whatever your terms are – and that is if you get paid on time!
This is where a cash-flow statement comes in: it starts by showing the operating profit for the business and then reconciles this to show how much money has actually come in/out over the course of the year – and it’ll be different due to these timing differences.
You also have to take non-cash items into account – in other words, your capital expenditure (see below). That's money you spend on fixed assets where the physical cash leaves your account straight away in one go, but you show and spread the cost over a number of years via depreciation.
You may also carry some unpaid invoices into the next financial year too – so while you showed the profit from the invoice date, some of these invoices will be carried into the next years as debtors.
If people pay faster, from a cash perspective that gives you a boost, but it doesn’t affect your profit. This also works the other way around with your creditors – both can give a different picture in terms of profit versus cash.
Scenario planning can help you to identify whether or not your cash balance is actually as comfortable as it might look on paper, and whether it’s enough to cover future needs.
Capital expenditure – what is it and why do we have it?
One of the key things that business owners struggle to understand when it comes to company finance and accounting is capital expenditure.
Capital expenditure is money that you’ve spent to purchase fixed assets – also called non-current assets or capital items. Fixed assets are items that you buy and pay for, but offer value to your business longer-term, such as:
With these, although the physical cash leaves your account at the point of purchase, because you’ll continue to get value from them, you show and spread the cost over a number of years.
So in the purchasing year, you’ll likely have an actual expense of the initial amount, but you show the cost in your accounts as a proportion of the total for a set amount over the years, with the entire value being accounted for when that time period has elapsed.
Treating fixed assets according to the matching/accruals principle
The matching principle means that the way you spread the cost of your fixed assets is via a process called depreciation.
Depreciation – not market value
Effectively, depreciation is like a usage charge and essentially a best guess of how long it will be used by your business to generate revenue. It allows you to spread the cost over the lifetime of its service in a fair and consistent way.
What is EBITDA?
When business owners start delving into the world of accounting and finance, they’re often confused by the acronym EBITDA.
EBITDA stands for:
It’s an international measure of financial performance, including all direct and indirect costs – before the business has paid corporation tax and any interest but also excluding depreciation and amortisation. It’s also often used to help value a business when used in conjunction with an earnings multiple.
Why depreciation and amortisation are excluded
Depreciation and amortisation are excluded from the calculation for two reasons.
First, two companies that are similar could have different depreciation policies, and can’t easily be compared.
Secondly, depreciation and amortisation aren’t allowable costs for corporation tax due to their subjective nature.
Therefore, by stripping these elements out, it ensures an objective view that allows a direct comparison of performance between businesses.
While these calculations offer an overview of your businesses operational performance and financial effectiveness, it’s essential to note that what ‘good’ looks like will vary from sector to sector.
You need to consider the nature of your business and the sector it operates in to get a full understanding of whether it’s performing well or not – and ensure that you’re not comparing to a business that has a completely different operating model.
Personalised finance options for start-ups, small businesses, sole traders, freelancers and other business professionals. Take the Access to Finance tool and get recommendations tailored to your financial needs.