If I’m profitable, where did my cash go?

This time of year small business owners who only infrequently take a glance at their financial statements may be getting a full year P&L delivered by their bookkeepers. If you put an ear to the wind, you can almost hear the moaning – “If I have this much profit, how come I don’t have any money in the bank?”

Assuming the profit is calculated properly, there are, of course, only three possible answers to this complaint. Understanding how financial statements work, may not make the answer any more pleasant but it can silence the frustration.

The first possibility is that the business spent money on assets. Capital expenditures don’t hit the P&L so cash is used up but, in return, the company has a shiny new widget machine, or more inventory, or perhaps (depending on the accounting basis) it made a sale on credit (thus generating a paper profit). And now it has recorded some accounts receiveable, A/R being another liquid asset (hopefully), just not as liquid as cash.

The company might have also reduced some liabilities. Again, this is a typical use of cash but it doesn’t show up on the P&L like payment of current expenses. The business owner may not have made a purposeful reduction of debt. It might be just the routine principal portion of a business loan or payment of certain kinds of taxes. For instance, making a sales tax payment shouldn’t normally impact the P&L because the best practice is to record net sales. A business owner with one eye on the checking account might be counting some of the collected sales as his own working capital – a terrible practice. When the payment is made — whoosh – a bunch of cash is gone.

The third possibility is that cash went out of the company through the equity section as an owner’s draw. One would think the owner would have a fond recollection of withdrawing some of his hard-accumulated capital but sometimes memories are short. Or when personal cash was tight, the owner might have paid some personal expense and the bookkeeper dutifully booked it for what it was – an owner’s draw. Since most small businesses are “pass through” entities for income tax purposes, this contributes to mental confusion at tax return time. The entity might have no responsibility for income taxes but the owner certainly does. Guess which checkbook is used when the IRS payment is made? Again, a reduction of cash and an owner’s draw is taking place, not a reduction of profit by generating an expense.

Understanding the fundamental mechanics of small business bookkeeping is an essential skill for an owner that will lead to better planning, decision-making and less confusion and stress. Using the Statement of Cash Flows which QuickBooks can spit out in seconds is a good way to evaluate what’s happening in your business.

— Frederick Welk
CEDF Business Advisor


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