What is the difference between cash and profit?

Understanding the difference between cash and profit is essential when running your own business.

Let's start by considering a few key definitions:

• Cash is easy to define, this is simply the money available in your company’s bank account. As a business owner it is understandable to think, I have lots of money in the bank therefore I must be really profitable or conversely I don’t have any cash, I must not be profitable – in both cases, this is not necessarily true.
• Profit can be measured in different ways depending on what level of performance a business owner is trying to review (more on this later) – but in essence, it is your revenue minus your costs.
• Revenue is all the money that comes into the business (excluding VAT!) whereas profit is the money the company has left once costs have been accounted for.
• Most companies will use the accruals method for accounting, which records income and expenses when they occur as opposed to when the cash is physically received or paid out. For example, if you issue an invoice on the 1st of the month, when you have provided the good or service to a customer but do not get paid until the 31st, the revenue is recognised on the 1st, when the invoice is sent. Similarly, if you are billed by a supplier on the 1st, but do not pay it until the 31st, the bill is recognised on the 1st.

In the short term, you might find that cash and profit are different, and depending on the time of the year one may be higher or lower than the other. Over time, cash should equal profit.

Most companies are established to make a profit, it is a key measure of success. Generally speaking the more profit you make the better your company’s performance. However, there are different profit measures to consider, and you may find yourself asking why revenue might be up but you don’t seem to be making more profit.

There are two main types of profit that a business should consider at a minimum; gross profit and net profit.

Gross profit is everything you have left after removing all direct costs of goods or services from your sales. The calculation for Gross Profit is as follows:

Gross profit = Sales – Cost of goods or services sold

Direct costs are also known as variable costs as they should be linked to the volume of sales you make, i.e. your direct costs will likely increase proportionally to sales (ignoring for now any discounts you might secure from suppliers for buying in bulk or discounts offered to customers).

For example, if you sales price is £10 per unit and direct cost is £6 per unit, the more you sell, the higher your revenue will be in multiples of £10 and the higher your cost will be in multiples of £6. The Gross profit per unit is always £4.

Using the above, if you sell 1,000 units in a year, your sales will be £10,000 and your cost of goods sold will be £6,000, leaving a gross profit of £4,000.

Net profit takes into account gross profit and then deducts all other expenses, including overheads or fixed costs that don’t necessarily change with each additional unit sold, such as cost of finance (e.g. interest), depreciation of fixed assets and tax. Calculating net profit is as follows:

Net profit = Gross profits – Overheads – Interest – Tax

So using the example above, if the business spent £1,000 per year on rent, £500 on utilities, £500 on staff, £100 on interest and £400 on tax, the net profit is £1,500.

Keeping track of a business’s cash, expenses, and profits can be time-consuming but having reliable, up-to-date information will allow you to make the best decisions for your business.

At Bright Beany, we love keeping track of the numbers and supporting businesses. By using our Digital Bookkeeping Service alongside our Management Accounts package you’ll have a clear picture of your business's performance and a partner to support with analysing the numbers and decision making.