Lesson 1: Why Profitable Businesses Run Out of Cash

Profit and Cash Are Not the Same Thing

Many small businesses that close down were making a profit when they did. They closed because they had no money in the bank on the day a bill was due. This level explains how that happens.

This course is educational only. It is not financial or tax advice. For decisions about your own business, especially tax, borrowing or a cash shortage, speak to a qualified accountant.

Here is the difference in one sentence:

Profit is what you earned in a period (sales minus the costs of making them). Cash is the money actually in your bank account on a given day.

Think of a salaried employee who is owed a £3,000 pay rise backdated to January. On paper they are better off. If the money does not arrive until next month, though, their rent is still due on Friday. A business works the same way. Bills are paid with cash. Profit cannot pay them.

The Example Business: Harbour Mugs

Harbour Mugs prints branded mugs for cafés. Here is how it trades:

• It invoices cafés when it delivers, and the cafés pay 60 days later.
• It pays for blank mugs one month before it sells them, so stock is ready.
• The mugs it sells cost it 40% of the selling price.
• Rent and wages (overheads) are £3,000 a month.
• It repays £1,000 a month off a bank loan it took out earlier.
• Sales are growing: £8,000 in April, £10,000 in May, £12,000 in June. It expects £14,000 in July.
• It had £10,000 in the bank on 1 April.

Three Reasons a Profitable Business Runs Short of Cash

1. Slow-paying customers. A sale counts towards profit when you make it, but the cash arrives only when the customer pays. Money that customers owe you is called debtors (US: accounts receivable). The faster you grow, the more cash is tied up waiting to be paid.
2. Stock bought in advance. You pay suppliers before you sell the goods. Your profit only counts the cost of the mugs you sold, but your bank pays for the mugs you bought. (UK: stock; US: inventory.)
3. Payments that are not expenses. Some payments reduce your bank balance without reducing profit:
   • Loan repayments. The part that pays back the amount you borrowed is not a business expense. Only the interest is.
   • Tax payments. VAT you collect from customers belongs to HMRC, not to you. For most VAT-registered businesses it is paid quarterly, by one calendar month and 7 days after the end of the VAT period. For example, a quarter ending 30 June is due by 7 August. A company with profits up to £1.5 million pays Corporation Tax 9 months and 1 day after the end of its accounting period, so the profit is earned long before the cash leaves. (These are UK rules. Other countries differ.)

Task: Build the 3-Month Profit vs Bank Spreadsheet

Open a blank spreadsheet and follow these steps.

1. Set up columns. Put labels in column A. Type April, May and June in cells B1, C1 and D1.
2. Build the profit section:
   • A2 Sales invoiced: enter 8000, 10000, 12000 in B2:D2.
   • A3 Cost of mugs sold: in B3 type =B2*0.4 and copy it across to D3.
   • A4 Overheads: enter 3000 in each month.
   • A5 Profit: in B5 type =B2-B3-B4 and copy it across.
3. Build the cash section:
   • A7 Opening bank: in B7 enter 10000. In C7 type =B12 and copy it to D7. Each month starts with last month's closing balance.
   • A8 Cash from customers: enter 5000, 6000, 8000. These are February, March and April sales arriving 60 days later.
   • A9 Stock paid for: enter 4000, 4800, 5600. This is next month's stock at 40% of next month's sales.
   • A10 Overheads paid: enter 3000 in each month.
   • A11 Loan repayment: enter 1000 in each month.
   • A12 Closing bank: in B12 type =B7+B8-B9-B10-B11 and copy it across.
4. Add totals:
   • A14 Total profit: in B14 type =SUM(B5:D5).
   • A15 Change in bank: in B15 type =D12-B7.
5. Optional chart: select the Profit row and the Closing bank row and insert a line chart. The two lines move in opposite directions.

Task: Check Your Spreadsheet

Compare your results with these figures:

• Total profit should be £9,000.
• Change in bank should be -£7,400.

If your numbers differ, check these three points:

1. Does C7 point to B12 and not to B7?
2. Is the cost of mugs sold based on this month's sales, while stock paid for is based on next month's sales?
3. Did you leave the loan repayment out of the profit section?

Explain the gap. For April, add up three amounts:

• Sales not yet paid for: £8,000 - £5,000 = £3,000
• Extra stock bought: £4,000 - £3,200 = £800
• Loan repayment: £1,000

That is £4,800, which is exactly the difference between April's profit (+£1,800) and April's change in cash (-£3,000). Now do the same sum for May and June.

What to notice: Harbour Mugs is growing and profitable every month, but its bank balance is falling. A month with an unexpected bill or a late-paying café could leave it unable to pay wages. If you see this pattern in your own business, talk to your accountant early, not when the account is empty.

Key Takeaways

• Profit is what you earned in a period. Cash is what is in the bank today. Bills are paid with cash.
• Customers paying slowly, stock bought in advance, and loan or tax payments that are not expenses all drain cash while profit stays the same.
• Growth can make the problem worse, because each month more cash is tied up in unpaid invoices and new stock.
• Always put monthly profit next to the month-end bank balance. A rising profit with a falling balance is an early warning.
• UK VAT is usually paid quarterly, one month and 7 days after the quarter ends. Plan for it. It is not your money.