Building a successful business needs far more than the great product or service that you have. It also requires that you occasionally spend some of your limited time dipping into financial reports. It makes sense to ensure that you use that time wisely, so in this post we’ll be discussing two essential reports that provide a quick and easy overview of both your profitability but also the financial health of your business.
Those two key tools that help you stay on top of your business’s health are the Profit and Loss (P&L) Statement and Cash Flow Forecast. Understanding the difference between the two and why they are so important will help keep your business on track for long-term success.
What is a Profit & Loss Statement?
A Profit and Loss Statement (also called an Income Statement) summarises your business’s profitability over a given period, such as a month or a quarter or a year. It tracks:
- Revenue: The money you earn from selling your products or service.
- Expenses: Costs such as rent, salaries, raw materials and marketing.
- Profit (or loss): The difference between your revenue and expenses.
Assuming that your finance team has processed everything correctly, a P&L statement answers the question:
“Is my business making a profit or a loss?”
For example: If your company made £100,000 in sales in August and had expenses (salaries, rent and cost of sales) of £80,000, your P&L would show a £20,000 profit for August.
What is a Cash Flow Forecast?
The Cash Flow forecast, on the other hand, is looking into the future to show you how much cash you are likely to have. It also shows if your business will be able to meet its financial obligations.
It includes:
- Cash inflows: Money due from customers, loans or investments
- Cash outflows: Payments for things like salaries, VAT, suppliers and rent
- A Cash Flow Forecast answers the question:
“Will I have enough cash to pay my bills as they fall due?”
Example: Using the above example, let’s say that the £100,000 sale related to just one customer and they didn’t pay for 60 days. If you started the month of August with just £20,000 in the bank, then you would actually not have sufficient funds at the end of the month to pay the £80,000 of expenses:
Cash at start of August £20,000
August expenses (£80,000)
Cash from customer £0
Cash shortfall (£60,000)
Why you need to monitor both your Profit & Loss and Cash Flow
Liquidity
A P&L might show you that you’re making a profit (or loss) but as we’ve seen from the above example you could run into trouble if your cash isn’t coming in when you need it.
Without a cash flow forecast, business owners can easily get caught out when their VAT or corporation tax becomes due as these payments can often get overlooked.
Overconfidence
If you only focus on your P&L, you might feel confident because you’re showing a profit. However this assumes that your P&L is correct. What if the payroll journal doesn’t get posted? What if you don’t accrue for costs correctly? These mistakes will result in your P&L being understated and so your business might not be performing as well as you think it is.
Planning for growth
A P&L will help you understand your company’s profitability over time, which is important for long-term growth. However, without a Cash Flow Forecast, you might invest too much too soon (for example by hiring additional staff or upgrading equipment) without realising that your cash reserves won’t cover the costs in the short term. It can also indicate if your business is at risk of “Over-trading” (essentially where a profitable business ties up too much cash in working capital, such as stock and debtors).
Having a Cash Flow Forecast will highlight future periods where cash flow might be tight.
Knowing this in advance would mean you could plan ahead appropriately, by arranging a short-term loan or reducing expenditure elsewhere.
In short:
The P&L looks back on performance and helps you see if your business has made money.
The Cash Flow Forecast looks forward so you can anticipate cash needs in the future. Both are vital and both allow you to grow your business profitably and sustainably.
An example with graphs for those visual people:
This graph illustrates a company’s expected P&L for the current financial year.
It is profitable for each month although in April and August, the profit is minimal. The green line gets close to, but does not go below, zero.
Assuming that all money from customers is received in 30 days and that overheads/expenses are paid out in the month they are incurred, then the graph below shows the expected cash flow for the same business (please note the company starts with cash reserves of £50,000):
Looks good, doesn’t it?
But what happens if customers don’t pay on time?
What if you still have to pay salaries and other costs in the month they are incurred but you don’t get the money from your customers for 90 days?
The reality could be more like this:
As you can see, by March the company would have run out of money (as the green line goes below zero). By June it is £100,000 short of cash.
And yet this is a profitable company. The top graph remains the same.
This is clearly an extreme example, but all that has changed in the graph above is the expected receipt date from all customers (changing it from 30 days to 90 days).
Profit & Loss versus Cash Flow Support
If this surprises you, or if you are thinking that this all sounds well and good, but you just don’t have the time to figure this out yourself, it might be time to think about bringing some support into your business.
We specialise in providing Fractional Finance Directors – finance experts who relish the opportunity to get stuck into your reports – for businesses just like yours.
Call us now on 020 8191 2124 or email FFD@artemisclarke.co.uk to find out how we can help keep the cash and profits flowing.
