Why a profitable business runs out of cash

Profit in the accounts is counted when a sale is invoiced and a cost is incurred. Cash moves when a customer pays you and when you pay a supplier, HMRC or the bank. A business can show a profit for the year and still struggle to pay the wages, because the two are counted at different times. The difference usually goes to one of five places.

Customers paying late

Each extra day customers take to pay holds back a day of sales. A business invoicing £600,000 a year bills about £1,644 a day. If customers move from paying in 45 days to 60 days, a further £24,658 is owed to the business at any one time, and that money is missing from the bank.

The debtor days calculator works this out from your own sales and the amount customers owe you today.

Stock and work in progress

Materials, stock and the wages of people working on unfinished jobs are paid before the customer is invoiced. A builder pays for a month of labour and materials before the first valuation is certified. A shop pays for stock months before it sells. When sales grow, the amount tied up grows with them.

Growth

A business that grows quickly pays for the extra staff, stock and materials before the extra sales are paid for. Take a business whose sales rise from £50,000 to £70,000 a month, with direct costs at 60% of sales paid in the month they are incurred, and customers paying after 60 days.

The extra sales are profitable, and the business still needs £24,000 from its bank balance, an overdraft or a loan to reach the month when customers start paying for them.

Loan repayments, equipment and money taken out

The profit and loss account shows the interest on a loan, and the repayments of the loan itself leave the bank as well. A van or a machine bought for cash is spread over several years in the accounts and paid for on the day. Dividends and drawings come out of profit after it is counted. All three take cash that the profit figure still shows.

Tax paid months after it is collected

VAT is due one month and seven days after the end of each VAT quarter, and Corporation Tax for most small companies is due nine months and one day after the year end (GOV.UK). VAT collected from customers and PAYE deducted from wages sit in the current account until they are paid over, and look like spare cash until the bill arrives. Moving them to a separate account on the day they come in keeps them out of the way.

Seeing it coming

A 12-month cash flow forecast puts each of these in the month it happens: sales in the month customers pay, wages and suppliers in the month they are paid, VAT and Corporation Tax in the months they are due, and loan repayments when they leave the bank. Rolled forward every month, it shows a tight month weeks ahead, while there is still time to chase customers, delay a purchase or arrange finance.

The guide on how to read a cash flow forecast goes through each line.