17th Jan 2012 / 12:58pm

‘Turnover is vanity, profit is sanity but cash is reality.’  This neat saying, known as the ‘Banker's Mantra,’ is everything a business needs to remember about financial control.

Here’s why. I’ll start with profit - the sanity.  The reason for being in business is to make money, and profit is the measure of a business’s ability to make money .... or loss if it isn’t doing well.  

Nothing in this life is ‘free’ so the Inland Revenue tax your sanity which is why some  businesses may want to keep their reported profits to a minimum. However for the  the purpose of this short blog I’m only focusing on operating profit, that is the  profit earned from a business’s core business operations.  It’s also known as EBIT - earnings before interest and tax. 

As I’m blogging about profit and cash I’ll only mention vanity in so much as it’s all the revenue a business generates from its operations. As it’s the largest number in the profit and loss account it’s what companies can boast about

A business can’t focus on just profit and turnover alone because the process of generating revenue needs cash because:

• creating the products of services it sells
• getting these to market
• employing staff
• office facilities, office overheads
• purchasing assets such as computers

all need cash.

These costs happen in advance of the product being produced and sold so cash is an essential ingredient.   It doesn’t matter where the cash comes from - whether it’s generated by the business or provided by investors or borrowed from the bank, but without cash a business cannot survive.

Some business owners and managers think that if they are in profit they should have cash and can’t understand when they don’t.  It’s sometimes caused by them focusing on the P&L, which doesn’t show cash movement, rather than looking at the balance sheet and cash flow forecasts.

The reason that profit and cash aren’t the same thing is timing.  There are two aspects to this.  Firstly cash is needed to produce and sell a product or service, and secondly accounting conventions use the tax date of an invoice as the moment the profit is recorded, not the payment of the invoice.  For the majority of businesses the cash received for payment of an invoice is not on the day it is raised.  Consequently there needs to be a buffer of cash to carry on the business.

Taking this a stage further a company can be highly profitable on paper but because of the disparity between paying the cost of sales and overheads and receiving payment for invoices mean the company has no cash. If the cash outgoings are greater than the cash coming in the company may go into receivership. It’s called overtrading.

Profitability is a function of the company’s ability to maximise revenues from their cost base - namely their direct and indirect costs and assets. Having sufficient cash in the bank to continue the operations that generate profits is the proof of management’s ability to:

• minimise the amount of cash tied up in stock
• cost control
• minimise the time it takes for invoices to be paid - the debtors
• generate a greater margin than depositing the same money in the bank

So - to answer the question - is cash or profit more important and why - cash is the most important as the business cannot continue to carry on day to day operations in the current market without. Banks will foreclose on overdrafts.

However the end game for any business is both - as profits are the purpose of being in business and these can only be enjoyed by the business owners if there is sufficient cash to distribute the profits.

If you need help understanding your business finance give me a call on 020 3286 7224 or 07718 584811 or send an e-mail to sarah@sfmconsulting.co.uk.

Posted by Sarah Matthews in: Small Business
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