Clients sometimes ask “I’ve made a £50k profit so why haven’t I got £50k in the bank?”
We the reason is something called working capital which is the cash tied up in the day to day running of the business.
Example
Scooby Doo and Shaggy both have identical Scooby Snacks businesses (£250k sales and £50k of profit).
Scooby Doo however:
- Holds a high level of stock
- Pays all his suppliers up front
- Is slow to invoice his customers and never chases them if they don’t pay
Shaggy on the other hand:
- Holds a minimal level of stock as he has an efficient stock system
- Pays his suppliers 30 days from end of month of invoice as per agreed credit terms
- Has all his customers pay him up front
Looking at the Balance Sheet of both businesses below:
Scooby Doo has stock of £20k and debtors of £40k so his profit of £50k has turned into an overdraft of £10k as he has negative working capital of £60k.
Shaggy has stock of only £1k (due to his stock system), no debtors (customers pay up front) and creditors of £20k (paid to agreed terms). Therefore his profit of £50k has turned into cash of £69k (profit of £50k plus positive working capital of £19k). A MASSIVE £79K MORE CASH THAN SCOOBY DOO FOR A BUSINESS THAT MAKES THE SAME PROFIT.
Recent Posts
- Sole trader or Ltd. What is the difference in tax payable? Watch this video
- Manage your pay within tax bands and avoid paying tax at 60%
- Setting up a new business right first time
- Increasing profits by increasing sales
- Why profit doesn't equal cash!
- Are you on the VAT Flat Rate Scheme? Make sure you watch this!
- Know your numbers to grow your business
- Could your Ltd reduce its corporation tax?
- Claiming business mileage as an employee
- Do not assume HMRC are always correct
- Why does profit not equal cash? Working capital explained
