There’s no money in the bank! How can I be making a Profit?
Perhaps the number one question that business owners ask their accountants, particularly when we emerge out of an economic downturn. “There’s no money in the bank! How can I be making a Profit?” In this article I tackle two different theories of though on why we get the same question over and over again.
Many business owners run their business on what I refer to as Bank Account Theory; whereas I would tell business owners they need to run on what I refer to as Financial Statement Theory.
Bank Account Theory is simply the following: “if I have money in the bank, I assume there is profit on the books. No money in the bank then there must be a loss on the books”. As a business owner you understand that bank account balance is important. Cash flow needed to run your business is very important as you rely on cash to run your business on a day-to-day basis. But, this is just one aspect of running your business and cannot be the only aspect.
So why do I have profit on the books and no money in the bank?
Now that we understand Bank Account Theory, let’s explore what happens when a downturn occurs in the economy. Business owners generally experience a dramatic decline in business and revenues. No business owner wants to close the doors of their business because revenues are not keeping up with the expenses. They often, resort to credit cards and lines of credits to run their business. This is fine at first glance. However, when the business starts to recover the credit lines are still there and the debt is still there. At some point in the business cycle, it will need to start paying back those loans. This is where the entire question becomes the answer.
Transactions made on your credit card or business line of credit to pay for expenses get reported as expenses on your financial statements in the year you made the expenses. When you pay back those loans you are NOT receiving an expense benefit on your financial statements or income tax returns. Money used to pay for loans is NOT an expense.
So how does this work?
Let’s say in 2018 there is a decrease in sales due to a downturn in the economy resulting is a loss of 22,000, against which the owner takes out loans. At the beginning of 2014 the owner has a debt of 25,000 to pay back.
In 2019 there is an upturn in sales as consumer confidence picked up. The owner decides to aggressively pay back the loan with the 12,000 profit that has been made. Using Financial Statement Theory, this leaves a balance of 13,000 (for simplicity I assume no interest). The payment of 12,000 went to pay back loans that technically is not an expense even though it reduced the bank balance.
Where the problem comes for business owners!
2019 will be profitable but there is no money in the bank because you are repaying debt. The business received the benefits in the 2018 financial year. This is when all the expense were written off. In 2019 the business will see no benefits of their loan repayment (assuming no capturing of previous years losses).
In 2018 the business experienced tough times. Therefore, in 2019 and most of 2020 and perhaps beyond times will be tough because you need to recoup those loans that were taken out in 2018. THIS IS NOT A QUICK FIX. As a small business owner you need to have patience when it comes to paying back the loans and returning profitable financial statements to a surplus bank balance.
This is why it is extremely important that your accountant gives you an accurate statement of revenues and expenses as well as a balance sheet because both of them work side by side in understanding your business.