Profits versus cash

Profits versus cash: I hear the comment many times: How come I have made this much profit but I have no cash in the Bank?

There are many cash flow models to show how cash is created and absorbed in a business. A lot are complicated spreadsheets that are not readily easily understood.

I hope this briefing will provide you with a simple grounding in order to understand how cash is created and absorbed in a business.

So how is cash created and absorbed in the business?

Stage 1

One of the simplest models is to start with the following table for the 12 month period

Sales/revenue – excluding VAT 100
Cost of goods sold (   )
Gross margin (   )
Operating costs (   )
Depreciation (   )
Interest cost (   )
Tax (   )
Profit/loss after tax  

If you complete this table using your management or financial accounts then always take the revenue at £100 or 100% and complete each line expressing the numbers effectively as percentage of sales for each of the lines to come down to a profit or loss after tax.

For example a company with sales of £390,000, costs of goods sold of £230,000, operating costs of £109,000, depreciation of £16,000, interest costs of £19,000 and tax of £12,000, the first part of the model would be completed as follows

Percentage of sales

Sales/revenue – excluding VAT 100
Cost of goods sold  (59)
Gross margin  (41)
Operating costs  (28)
Depreciation    (4)
Interest cost    (5)
Tax    (3)
Profit/loss after tax     1

So what does this tell us?

Essentially it shows that for every £100 of sales, the company makes £1 after tax.

More importantly it shows where the £99 disappears too.

So ask yourself is this result better than the last five years or compared to the next forecast. How do competitors compare?  Is there a problem in volumes, pricing, cost, structure, capital spending or capital structure?

Stage 2

On the second half of the same piece of paper your will need to look at the cash changes in the business for each £100 of sales.  So using the following example cash movements may occur:

  • Decrease in stock of £20,000
  • Increase in accounts receivable of £40,000
  • Decrease in accounts payable of £35,000
  • Capital expenditure of £25,000
  • Loans raised of £40,000
  • Dividends paid of £15,000

This translates into the following table but note that the figures are expressed as a percentage of sales.

Percentage of sales

Profit/loss after tax 1

Say depreciation 4

Decrease in stock 5

Increase in accounts receivable (10)

Decrease in accounts payable (9)

Capital expenditure (6)

Debt raised    10

Dividends paid (4)

Decrease in free cash (9)

In this example therefore the company that has £100 as sales has translated £9 into cash outflow – that is money drawn out of the business.  Compared to £1 profit after tax.

How is this done?

In order to cover the total £10 spent on capital expenditure and dividends the business had to borrow money from the bank.  There was not enough profit generated to cover these outgoings.

Purpose

The purpose of this model is not to be an accounting exercise merely a tool to help you to raise questions on the financial performance of the business.

I agree this is a simple model but it can be quickly constructed and it will point out where there may be potential problems. It can tell you how your business either generates or absorbs cash.

In this for example, an increase in account receivable ends up as an outflow of cash.  This is simply because less cash has been generated since sales have not yet been converted into cash.

The real purpose of the model is to enable you to step away from the detail of your existing management information and be able to convert financial statements quickly into useable models.

The role of Assynt Corporate Finance.

If you believe this model would be of use to you but would like more explanation then please contact me.

We are able to look at more sophisticated models and look at some of the drivers of a business and how they contribute to the overall free cash flow generation of the business and hence its valuation.

If you believe that we can help you then please contact Andrew Watkin on email: awatkin@assyntcf.co.uk or telephone 07860 898452.

 The information contained in this briefing is based on information available as at the date posted and may be subject to amendment.  It is written as a general guide and is not a substitute for professional advice.  You are strongly recommended to obtain specific professional advice from us before you take any action.  No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this briefing can be accepted by Assynt Corporate Finance Limited or its employees.

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