There is a particular confusion that arrives with the first real set of financial statements. The profit and loss says the business made money. The bank account does not appear to agree. Neither number is wrong, and the gap between them is not an error waiting to be found. They are measuring two different things.
Profit tells you whether the business is working. Cash tells you whether it can meet its obligations this week. A business can look sound on one measure and be under real strain on the other, which is why the two are worth understanding separately.
Where the two numbers separate
Four things account for most of the distance between them.
- Timing. Work is recorded when it is done; payment arrives when the customer gets to it. A strong month of invoicing shows up in profit immediately and in the bank account thirty or sixty days later. The same runs in reverse for bills you have received but not yet paid.
- Money that leaves without touching profit. Loan principal, owner draws, and equipment purchases all reduce the bank balance without appearing as expenses. The interest on a loan is an expense; the principal is not. A truck bought outright is not a cost in the month it is bought. It is an asset that becomes a cost gradually.
- Costs that touch profit without moving money. Depreciation is the clearest example. It reduces profit every month to reflect equipment wearing out, but nothing leaves the account. This is how a business can post a loss on paper and still hold a perfectly healthy balance.
- Money in the account that is not yours. Sales tax collected, payroll amounts withheld, and deposits taken for work not yet delivered all sit in the bank account looking like available funds. They belong to someone else, and they leave on a schedule you do not set.
If your books are kept on a cash basis rather than accrual, the first of those largely disappears, because income and expenses are recorded when the money actually moves. The other three do not. They are structural, and they persist whichever basis you use.
Which number answers which question
Profit answers questions about the shape of the business: whether the pricing is right, whether margins are holding, whether a particular service line is worth continuing. It is the measure to reach for when deciding what the business should be doing.
Cash answers questions about the next ninety days: whether payroll can be met, whether there is room for a hire, whether an invoice needs chasing this week rather than next. It is the measure to reach for when deciding what the business can afford to do.
Using one to answer the other’s question is where most of the trouble starts. A profitable business that runs out of cash closes just as firmly as an unprofitable one.
What current books give you
None of this calls for a forecast or a spreadsheet built for the purpose. It calls for the books to be current and reconciled, because both numbers are only as good as the records underneath them.
When accounts are reconciled every month, the bank balance is real rather than approximate. When transactions are categorized soon after they occur, the profit figure reflects what actually happened. And when receivables and payables are kept current, the distance between the two numbers becomes something you can explain rather than something you have to wonder about.
At that point the question stops being which number to believe. Both are true. They are answering different things, and each can be used for what it is good for.
If your books are not giving you a clear read on either number, we would be glad to take a look. Get in touch.