As a company in the financial sector, we often meet with business owners who have similar questions finance challenges. That’s why we’ve partnered with Martin Mellor of Mellor Financial Management to pull together a breakdown of some key information to try and mitigate these issues.
Over the years, I’ve noticed some key finance challenges that business owners struggle with. This blogs breaks down some of the jargon that comes with finance. It will bring you some golden nuggets of information to get you equipped with some of the foundations in finance.
Cash and profit are NOT the same thing
Understanding the difference between cash and profit can be hard for many business owners to get their heads’ around. While it’s a key finance challenge, it’s important to know how they differ and why this matters.
Out of roughly six million limited companies in the UK, approximately half won’t be trading in five years’ time. You might assume this is due to a lack of profit. Four out of five of them will stop trading because they’ve run out of cash – even though they may actually be turning a profit.
It’s possible to trade at a loss and still keep your business going, as long as you’re able to fund the business from somewhere. For many SMEs, this means injecting their own money into the operation to stay afloat.
It’s all about the timing
One of the primary reasons that cash and profit are different is to do with timing. An example of this is when you declare profit vs when you receive payments.
Cash availability is linked to working capital. This is how much money you’ve received from your customers, versus how much you’ve paid out to suppliers.
The timing of declaring profit is triggered by invoice dates. Most businesses use credit terms, so from an accounting perspective, you declare the revenue and profit from the invoice date. You may not receive the money for another 30 days, for example, and that is if you get paid on time!
Therefore, if your financial year runs from the 1st of January to the 31st of December, what you declare as revenue and profit is anything you’ve issued an invoice for during that period of time – but you may not actually have that cash in the bank yet.
This is where a cash flow statement comes in: it starts by showing the operating profit for the business and then reconciles this to show how much money has actually come in or out over the course of the year – and the chances are it’ll be different due to these timing differences.
When calculating profit, you also have to take non-cash items into account. An example of this could be your capital expenditure. This is the money you spend on fixed assets where the physical cash leaves your account straight away, but you show and spread the cost over a number of years via depreciation.
You may also carry some unpaid invoices into the next financial year. While you showed the profit from the invoice date, some of these invoices will be carried into the next year’s accounts as debtors. If people pay up faster than your terms dictate, from a cash perspective that gives you a boost, but it doesn’t affect your profit. This also works the other way around with your creditors. Both scenarios can give a different picture in terms of profit versus cash.
As there’s a difference between how much cash you’ve got and free cash flow (the cash your business actually has available to spend without restrictions) it’s important to understand these cash management distinctions. Scenario planning can help you to identify whether or not your cash balance is actually as comfortable as it might look on paper, and whether it’s enough to cover future needs.
The matching or accruals principle
The final reason that cash and profit are different is due to the matching/accruals principle. This is where you match the revenue generated with what it costs to generate it.
This might also mean that you’ve incurred a cost in order to produce something to sell but haven’t yet received the bill. Because of these potential scenarios, you may have shown a profit or loss without the cash having gone in or out.
This is why planning is so important – you need to keep close tabs on exactly where you are on paper, and in actual banked cash so you can get a true picture of your financial position.
Key Terms: Working Capital: how much money you need to sustain your business from day to day Free Cash Flow: the cash your business actually has available to spend without restrictions
Capital expenditure – what is it and why do we have it?
One of the key finance challenges that business owners struggle with is capital expenditure.
Capital expenditure is money that you’ve spent to purchase fixed assets – also called non-current assets or capital items. Fixed assets are tangible items that you buy and pay for, but offer value to your business longer-term, such as:
With these, although the physical cash leaves your account at the point of purchase/invoice terms, because you’ll continue to get value from them, you show and spread the cost over a number of years.
So in the purchasing year you’ll have an actual expense of the initial amount, but you show the cost in your accounts as a percentage of the total for a set amount over the years, with the entire value being accounted for when that time period has elapsed.
The reason we treat fixed assets separately is nothing to do with market value, but with matching cost and revenue.
Treating fixed assets according to the matching/accruals principle
The matching principle means that the way you spread the cost of your fixed assets is via a process called depreciation.
Ask yourself: ‘What’s a fair proportion of the cost of the asset, applied to the profit generated by the business?”
What is depreciation?
Effectively, depreciation is like a usage charge. It’s like a best guess of how long it will be used by your business to generate revenue. It allows you to spread the cost over the lifetime of its service in a fair and consistent way.
Consistency is key here and must be followed. This prevents businesses from manipulating performance for the year just by changing their depreciation policy. What those policies are in the first place is ultimately the subjective choice of the business. Although convention exists there are no hard and fast rules to what policies you set.
After purchasing a fixed asset, you may make decisions along the way such as selling it before it’s fully depreciated. However, that just triggers a different outcome.
What is EBITDA?
When business owners start delving into the world of accounting and finance, they’re often confused by the acronym EBITDA. Jargon like this is one of the larges finance challenges we come across, so let’s break this down.
EBITDA stands for:
It’s an international standard for the effectiveness of operations, and a calculation of operating profit. This includes all direct and indirect costs – before the business has paid corporation tax and any interest.
But it’s not a standard measure
That said, in its full form, EBITDA isn’t a standard measure of profit when it comes to accounting. Instead, we simply use EBIT: earnings before interest and tax.
It’s also referred to as operating profit and is a great way of measuring performance. It includes all direct costs of items sold and all business overheads, only excluding the tax and interest which are financing costs. It shows you how much money you’ve made from running your business on a day-to-day basis.
Why are depreciation and amortisation excluded?
In order to cleanse the data, depreciation and amortisation are excluded from the calculation for two reasons:
- Firstly, two companies that are exactly alike could have different depreciation policies, and can’t be compared like-for-like.
- Secondly, amortisation isn’t an allowable cost for corporation tax due to its subjective nature.
Therefore, by stripping these elements out, it ensures a completely objective view. This allows a direct comparison of performance between businesses.
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While these calculations offer an overview of your businesses operational performance and financial effectiveness, it’s essential to note that what ‘good’ looks like will vary hugely from sector to sector.
You need to consider the nature of your business and the sector it operates in to get a full understanding of whether you’re performing well or not. This will ensure that you’re not comparing to a business that has a completely different operating model.
If you would like to find out more about some of the financial terms and fundamentals you could be aware of as a business owner based on your, finance challenges, check out Martin’s website. Alternatively, keep an eye on our blog for more content coming soon from Martin.