Why is My Net Profit Different from my Bank Balance?
A few reasons.
Ok, so you want to know your numbers to determine the health of your business. Wonderful! The first place to start is to run a Profit and Loss report from your accounting software. Choose a date range such as the last Financial Year or the previous 12 months to get an up-to-date assessment.
When you have done that you will most likely notice your net profit is significantly different to your bank balance. So where has that money gone? The report shows your business has made a profit, but you have no idea where the money has gone. Don’t stress, this is normal.
In this short article, we will uncover a few reasons why there is a difference between your reported net profit and your bank balance.
Profit and Loss statements.
First, let’s unpack your profit and loss statement (P&L). This is a financial report generated by your accounting software that provides a summary of your company's revenues, costs, and expenses over a specific period of time. You can choose a date range such as the last Financial Year or the last 12 months. The primary purpose of a P&L is to show whether your business is making a profit or a loss. Ideally, study your P&L monthly, quarterly and yearly.
Here is a simple breakdown of key numbers to look at in a profit and loss statement:
Revenue (Sales): This is the total income generated by the sale of goods or services.
Cost of Goods Sold (COGS): Or Cost of Sales. It includes the direct costs of producing the goods or services sold like raw materials and manufacturing expenses. It excludes indirect expenses such as distribution costs and labour. Although some accountants like to include labour.
Gross Profit: Gross profit is calculated by subtracting the Cost of Goods Sold from the total Revenue. It represents a company's profit after covering the direct costs of producing its goods or services.
Operating Expenses: Includes all indirect costs associated with running the business. It may include items like wages, rent, utilities, salaries, vehicle costs, marketing expenses, and administrative costs. Some P&Ls also have an Other Costs section.
Net Profit: Shows the total profit or loss generated by the business after subtracting all expenses from all revenues. It is often referred to as the bottom line.
Profit and cash flow.
While net profit shows the overall profitability of your business, your bank balance reflects the cash flow and liquid assets available in your company's bank accounts at any given time. The bank balance provides a snapshot of your company's liquidity, or its ability to meet short-term financial obligations. Despite its importance, the bank balance doesn't provide a comprehensive picture of your business’s financial performance. It can fluctuate based on various factors, including accounts receivable (money still to come in), accounts payable (money still to go out), and timing differences in cash inflows and outflows.
Timing differences and accrual accounting.
A primary reason for the difference between your net profit and bank balance lies in the accounting method used. Most companies use accrual accounting, which recognises revenue and expenses when they are incurred (when you’ve invoiced a client), not when the cash changes hands. This means that revenue is accounted for before payment is received, and expenses are recorded before they are paid.
For example, if you invoice a client for services completed in December (say $15,000), the revenue is applied in December's net profit, even if the payment is received in January. This creates a timing difference between when revenue and expenses are recorded and when cash transactions occur, impacting the bank balance and the net profit reported in that period. In this case, your net profit would be $15,000 more at the end of December than your account balance.
Fixed assets are not classified as expenses.
Another reason your bank balance looks different from your net profit is you may have purchased a fixed asset during the time period you’re measuring. This could be equipment, a building, or a vehicle. Keep in mind that fixed assets are not classified as an expense and does not go on your P&L, but the fixed asset amount will still be deducted from your bank account if the items are paid for in cash. Fixed assets are expended over the expected lifetime of the asset using depreciation.
For example, if you purchased a vehicle for $50,000, your profit will be $50,000 more than your bank balance if you paid for it in full without a loan.
Owners drawings are not recorded as expenses.
Lastly, owners’ drawings are not recorded as expenses and will not affect (reduce) the reported net profit. It does, however, reduce your bank balance.
For example, if you withdrew $20,000, as owner’s drawings over the timeframe you are measuring, your profit will be $20,000 more than your bank balance.
Good for smart decisions. Good for profit.
Understanding the differences between net profit and bank balance is crucial for making smart financial decisions. While net profit provides a comprehensive view of your company's profitability over time, your bank balance reflects its immediate liquidity. Timing differences due to accrual accounting, fixed asset purchases, and owners drawings are key factors that contribute to the difference between these two financial metrics. You should consider both net profit and bank balance when assessing the financial health of your company.
Some business owners use the profit-first accounting method to help them be more mindful of their profit. This approach encourages business owners to put profit at the forefront of their accounting by setting aside a percentage of income into a profit account as soon as it is paid into your account.
For example, if your buisness has consitently returned 5% net profit over the past few years you can safely put aside 5% as soon as it is paid, depsoited into a profit account within your business. You can always transfer money back if cash flow is tight. This method usually encourages you to save more and spend less.
What you can do to increase your profit
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