The last two years have been challenging for our industry in many ways but there have also been a lot of positives. Whilst the day to day has been difficult, the growth pharmacies have seen has been significant.
As we close out the financial year and we assist clients in estimating their tax position. As a result of the growth they have experienced, one of the most common questions we get from clients is, why doesn’t my cash position reflect these profits I now have to pay tax on?
When small business owners receive their monthly financial statements, their eyes quickly focus on the bottom line of the income statement.
If profit meets their expectations for the period, they move onto the balance sheet to the cash balance, where they may be surprised to see that the cash balance didn’t grow as much as they thought it should.
To understand where your cash has gone, you must first understand the relationship between profit and cash flow, and how each is calculated.
Profit is shown on an income statement and equals revenues minus the expenses associated with earning that income. This measures the ongoing sustainability of the business.
Cash flow measures the ability of the company to pay its bills. The cash balance is the cash received minus the cash paid out during the time period. Negative cashflow indicates that the business has spent more money than what has been generated in the period.
To further illustrate the difference between cash flow and profits, let's take a hypothetical look at the activity in a business bank account:
There is $3,000 in your bank account from sales this month and previous months.
You need to pay rent on your office space of $1,100.
You also need to pay utilities ($220) and the locum who stepped in for Covid relief ($850).
That takes $2,170 out of your business bank account, leaving $830.
This month is the end of a quarter. Your profit for the quarter on your profit and loss statement is $5,200. But even though you made a profit, you can't take out more than $830 to pay yourself as the business owner because you don't have enough cash.
This scenario is common and for many pharmacy owners it can be very disheartening; particularly at a time when so much energy is being expended to keep on top of the day to day.
In most cases, this is not a reflection on the ability of the owners to operate their business. This anomaly between profits and ‘negative’ cashflow is essentially an accounting issue. It could be attributed to using cash for items that don’t show up on the income statement or it’s a timing difference in the recognition of revenue and expenses and their collection and payment. However, to truly understand the business’ full cash flow picture, a review of the cashflow statement is necessary.
A cashflow statement breaks down the cash transactions into 3 areas:
Cash Flows from Operations
Cash Flows from Investments
Cash Flows from Financing
Below are some examples of transactions that may contribute to the discrepancy:
1. Investing in Stock (cashflows from operations)
The recent requirement to purchase RATs tests resulted in an outflow of cash, however the Government rebate was received at a later date.
2. Debtors accounts (cashflows from operations)
Although not necessarily a major problem for pharmacy, there may be the odd period when the revenue is reported at the time of the sale, however the cash is not received till later.
3. Capital Investment (cashflows from investment)
Ordinarily any investment in capital items would result in a cash outlay but the expense wouldn’t be recognised until a later date. However, in the last two years, the government has offered numerous incentives to business to invest in capital items and receive an immediate deduction in the year the cash was outlaid.
4. Debt Reduction (cashflows from financing)
At a time when the cost of borrowing was cheap, overall borrowing increased. However, these debts do need to be repaid and this can impact on cashflow significantly. Now that interest rates are increasing there may be added pressure on pharmacy owners. It is important to note, that as only the interest is deductible, this is the only component to impact on the income statement. The principal repayment will not impact here and therefore it will add to the discrepancy.
5. Prepayment of Expenses
There may be instances when expenses are prepaid. However, only the expense relating to the reporting period in question will be deducted. From a cashflow perspective, there will be a hit for the total payment. However, the same won’t apply to the income statement and will allow for more profit to be reflected.
Which Is More Important - Profits or Cash Flow?
Now that we know why profit doesn’t equal cash, its common to hear owners ask what should we focus on – the profit or the cash position?
Both of these are important of course. Nobody intends to go into business to make a loss. However, without cashflow management and the ability to cover all expenses as they fall due, the owners may find themselves in a precarious situation.
We cannot stress enough, the importance of monitoring working capital. When the amount of cash you have tied up in debtors, creditors and inventory continues to grow in your business, it is likely that you will suffer cash flow shortages.
Unfortunately, when most businesses experience cash flow shortages, the knee jerk reaction is to cut expenses. In a lot of cases, profitability is sufficient it is just their cash conversion cycle that needs to change.
Essentially, the business is not converting their working capital to cash at a fast enough rate to fund their business operations.
Some of the key metrics that will be useful to measure are:
accounts receivable days (measures the average collection period);
inventory days (measures the average days that it takes to sell an item of inventory);
accounts payable days (measures the average number of days it takes to pay your suppliers); and
cash conversion days (this is a product of the above and determines how many days during the sales process that you will be required to fund working capital).
In short, profits and cash flow are both important and without one it is difficult to have the other; finding the balance is the key.
If you find yourself in this situation where you have good profits but are struggling with managing your cashflow and would like assistance with your cashflow position, please book a consultation with me here.
Written by Director Priya Narsing
