It is quite normal for a business to make a healthy profit in a month, but for its cash position to worsen, and vice versa.  It is actually highly unusual for changes in your cash and profits to be the same!

There are usually five reasons for this:

  1. Dividends
  2. Accruals and prepayments
  3. Debtors and creditors
  4. Expenditure – capital and revenue
  5. Provisions
  1. Dividends

Dividends are a distribution of profits to the Shareholders.  Dividends reduce cash resources but don’t affect profit (Ebitda).  A business can pay out dividends, thus reducing its cash balance, but this does not reduce the profit for the year, as it is a distribution of the profits.

A common problem for many businesses is that healthy profits have been made, but insufficient cash exists to pay the dividends.  Sometimes, the cash may exist but the payment of a dividend would leave insufficient funds available in the business for working capital.

  1. Accruals & Prepayment

Accruals

Goods or services used in a period prior to which they are paid for or invoiced.

Where do Accruals appear on the Balance Sheet?  An Accrual is a creditor due <1 year (i.e. a current liability).

Example:  Products the practice has used but for which the supplier has not yet invoiced, such as frames or lenses.

Pre-payments

A payment that is made in advance of the service or goods being used.  It will appear on the balance sheet as a current asset.  An example is rent as it is usually paid quarterly in advance.

Where do Pre-Payments appear on the Balance Sheet?  A pre-payment is a current asset.

  1. Debtors and Creditors

Debtors are people or businesses that owe your practice money!  Debtors represent the difference between sales and the payment (cash) you have received for these sales.  Whilst you may have made a profit on these sales, you haven’t received the cash – so profit will not equal cash!  To maximise cash in the bank, debtors should be kept to a minimum.

Control of these Debtors is vital to the financial health of the practice, with the primary example being deposit policy and management.

Where do Debtors appear on the Balance Sheet?  Debtors are a current asset.

Creditors are people or businesses to whom you owe money, e.g. suppliers, HMRC.  Creditors represent the difference between the purchases you have made for during the month and the cash you have actually paid.

Where do Creditors appear on the Balance Sheet?  Creditors are a current liability (creditors <1 year).

  1. Capital and Revenue Expenditure

Revenue Expenditure

Revnenue Expenditure is the day to day costs incurred in generating sales, e.g.cost of goods, staff costs.  The benefit from this expenditure is realised (and recorded) in the current accounting period.  It comprises the day to day running costs of the business.

Revenue Expenditure is recorded on the P&L.  This includes cost of sales and all overheads.  The expenditure detailed on the P&L may not equal a cash movement – for example rent, depreciation.  Rent is usually paid quarterly, so is a cash movement quarterly.  However, each period the P&L shows a figure for rent of 1/12th of the annual amount.  Depreciation is not a cash movement.

It should be remembered that the amount of Revenue Expenditure charged to the P&L for a year is the amount incurred for the period, irrespective of whether cash has been paid out or not (see section on Accruals).

Capital Expenditure

Can be defined as any expenditure incurred in creating, acquiring, extending or improving an asset for use in the business.  The benefit from Capital Expenditure will be enjoyed over a number of accounting periods.

An obvious example of Capital Expenditure is equipment.  Shopfitting and furniture are also treated as Capital Expenditure.

Most Capital Expenditure is also recorded as an expense (Depreciation) as within the P&L.  Please see an example in the Depreciation section below.

Summary

Revenue expenditure is charged to the Profit & Loss account.

Capital expenditure is not charged to the Profit & Loss account

  1. Provisions

A Provision is an amount charged against profits:

  • To provide for the reduction in the value of assets, or
  • For liabilities – the amount of which cannot be determined with reasonable accuracy.

A Provision reduces profit but not cash.

The best examples are Depreciation and Doubtful Debts.

Provisions are sometimes referred to as Reserves.

Depreciation

Is the method whereby the original expenditure on an asset is spread over its estimated useful life by a proportion of the value of that asset appearing in the P&L.  There is a corresponding reduction in the value of the asset in the balance sheet.

Example:  On 1 January 2014, I.C. Moore Opticians bought a new combi unit for £12,000, paid in cash.  It had an estimated life of 5 years and scrap value of £2,000.  In annual statutory accounts, cash was £12,000 less than it would have been if the asset had not been bought, but profit would be charged with one years’ depreciation of £2,000 (£12,000 – £2,000/5).

Your accountant will be able to advise on depreciation terms for any capital expenditure you are planning.

Doubtful Debts

Doubtful Debts reduce the asset debtors in the balance sheet.  Doubtful Debts also reduce profit in the P&L – but there is no effect on cash flow.

Uncollected balances for patients who have collected their glasses is the most common area for Doubtful Debts to arise.  Other examples are businesses to which you have provided corporate or domiciliary eyecare.

Why is Cash so important?

More businesses fail due to poor cash flow than insufficent profits.  Cash is required to:

  • Cover operating costs (overheads), e.g salaries, rent and cost of goods
  • Pay existing liabilities (including tax, loans,etc)
  • Allow for investment, e.g equipment and refits
  • Protect against unforeseen expenditure, e.g repairs, sickness cover
  • Take advantage of opportunities, e.g marketing of a new product

Key Factors Affecting Cash Flow

  • Planning of Capital Expenditure
  • Timing and amounts of dividends
  • Controlling working capital:
    • Stock
    • Creditors
    • Debtors