When it comes to small business, there is a common misconception that profit and cash flow will always match. Although this would be the ideal situation, a small business’s cash flow is often less than their bottom line suggests.
There are myriad reasons why there are differences between the cash flow and profit of a small business. The following ten reasons are the most common ones for this.
1. Director’s Loan
A small business that exists in the form of a company may often lend money to directors for various purposes. This treated as a loan that must be repaid to the company.
When the cash has not been repaid, it is not recognised as being within the company, which means that the cash flow and overall cash position of the company will be adversely affected. This loan will not affect the profitability of the company, but directors should be fully aware of any loans made by the company in the event its cash reserves are low.
It is common in some industries for provide product or service to on “account” which are paid to the business at a later date. As all invoices issued are recognised as revenue as soon as they take place and not when cash is paid, a small business’s financials may show more profit than cash when this occurs.
The cash flow of a business will also be affected if it has paid a large amount of cash they previously owed other stakeholders. For instance, if a small business had $100,000 in creditors last year and only $75,000 this year, its current year cash reserves would decrease by $25,000 as it has been used to reduce debt in the business.
4. Annual Leave Payments
Business who hire staff on a part or full-time basis must make provisions for annual leave their employees are entitled to take. Staff accumulate leave and take a number of weeks off work at one time, which could account for a difference in a business’s profit and cash position.
For example, a business that had $15,000 in their annual leave account one year, but only has $5,000 one year later, this would mean they have paid $10,000 in leave payments to their staff, which would obviously have an impact on cash flow. This is why it is important for small businesses to manage leave balances so that staff do not accrue for more than one years leave entitlements or to have a policy of putting money aside in a separate bank account to cover when staff go on leave.
5. Long Service Leave Payments
As with annual leave, a business must also make provisions for long service leave if it has part or full-time employees. If a small business owner is lucky enough to have loyal employees that stay with them long enough to accrue their long service leave, usually the employer will make provision for the leave in their balance sheet at the time the employee is entitled to the leave rather than when the employee takes the leave.
This would affect a business’s profit in the years the leave is being accumulated ie accrued, but would impact its cash flow in the year the leave is taken as the business would have to make a cash outflow in the form of leave payments. Again, it is always a good idea to have a separate bank account for this long service leave provision so you have the money available when the employee takes their leave, especially if an employee wants a full payout of their leave balance.
6. ATO debt
Many small business owners often start their business without obtaining professional tax advice, usually for financial reasons or because it does not seem like a priority in the various other things involved with starting and establishing a business.
By not fully taking tax implications into account, small businesses often run the risk of getting themselves into debt with the ATO. This can often get a business into a cycle of payment arrangements with the Tax Office, which incurs interest that can better be spent on the business. Therefore they often are paying historical tax debt with current year cashflow.
7. Late Superannuation Payments
One of the costs of having employees is paying their superannuation, and small businesses which are having issues with their cash flow often pay this after the due date. There are two adverse impacts for a small business’s cash flow as a result of late payment of employee’s superannuation entitlements.
Firstly, superannuation payments not paid by the due date are not allowed to be claimed as a tax deduction, which means a small business will have a lower tax refund after lodging its tax return, hence less money in their business. A small business may also have to pay penalties and interest on the late super payments, which means cash is unnecessarily taken out of the business.
8. Paying the Principal on Loans
When a business pays its loan, it is only the interest portion that reduces profit. The principal portion does not reduce profit, nor is it tax deductible, which can be a pain for the cash reserves of many businesses.
Loans are a simple and even an intelligent way of helping a small business establish itself. However small business owners should be mindful that paying off loans may affect its cash flow differently from its overall bottom line.
Leases work much in the same way as loans in that they partly consist of a principal component. This means that when a small business owner pays these leases, some of the payments are not reflected in the business’s cash flow.
10. Having Prior Year Losses
A company that has had prior year losses will also need to watch its cash movements as the business will have debts associated with those losses that need to be repaid. Those debts, which include loans, creditors and unpaid liabilities are commonly prevalent in recently established businesses, and are better paid before the losses accumulate to a point where they are out of control.
Our friendly team of professionals at Hart Partners would be please to discuss these options for your business in greater detail. A cashflow forecast is a valuable tool to help you identify potential shorfalls in cash before they arise. Call us today on 03 9600 3220 or book an appointment today.