Why profitable businesses can still run out of cash

Reviewed by Marc Gardner, senior content manager

I've spent more than 25 years working with businesses ranging from small owner-managed firms to companies turning over millions of pounds.

During that time, I've worked with plenty of business owners who can see a respectable profit in their accounts but can't see the same money in the bank.

The business is busy and customers are buying. The latest figures suggest it's performing well. Yet the owner is still wondering how to cover wages, suppliers or an approaching tax bill.

People often treat this as an accounting mystery. But, usually, it comes down to timing and where the business's money is tied up.

I put it this way:

"Profit tells you whether you've made money. Cash flow tells you whether you can keep on trading."

You need both. A business can survive a period of disappointing profit if it has enough cash or funding behind it. It can't carry on indefinitely without the money to meet its commitments.

Here, I explain why a healthy profit doesn't always lead to a healthy bank balance and what you can do before a cash shortage becomes a crisis.

1. What's the difference between profit and cash flow?

Profit is the income your business has earned over a period, minus the costs attributed to that period.

Cash flow is the money entering and leaving the business. It tells you whether cash is available when wages, rent, supplier invoices, tax and other payments become due.

The difference becomes clearer when customers pay after you've completed the work.

Example

Suppose your company uses traditional, or accrual, accounting. You finish a project on 1 June and issue an invoice for £10,000.

The direct and overhead costs allocated to the work come to £4,000, so the accounts may show a £6,000 profit.

Your customer has 60-day payment terms and doesn't pay until August.

During June and July, you still need to pay employees, suppliers, rent, insurance, software subscriptions and any tax liabilities that fall due.

The £6,000 profit exists in the accounts, but the £10,000 customer payment hasn't reached your bank.

This distinction depends partly on the accounting method your business uses.

• Cash basis accounting records income and expenses when money is received or paid. It's the standard method for many sole traders and partnerships without corporate partners.

• Traditional accounting records income and expenses according to invoice and bill dates. Limited companies must use this method.

You don't need to become an accountant to manage this. But you do need to understand what your figures are showing. A profit and loss report can contain income you haven't collected yet.

2. How a £20,000 profit can produce a fall in cash

Here's a simplified example. A business reports a £20,000 profit for the quarter. During the same period:

• the amount customers owe increases by £12,000

• another £5,000 is tied up in stock

• the company spends £4,000 on new equipment

• it repays £2,000 of loan principal

Those movements absorb £23,000. Assuming its other cash movements balance out, the company's cash position has fallen by £3,000 despite the £20,000 profit.

The profit figure isn't wrong. The cash either hasn't arrived yet or has been used in ways that don't appear as an equivalent expense in the profit and loss account.

That's why I'm wary when someone tells me the business is fine because it's made a profit. I want to know what's happening underneath that figure.

VIDEO: Why profitable businesses still run out of cash

In this accompanying webinar, I look at the most common causes of cash flow problems and share practical steps you can take to avoid costly surprises:

3. Why profitable businesses run out of cash

There's rarely one dramatic cause. Cash pressure tends to build through several smaller problems that reinforce each other.

Customers pay after your own costs fall due

This is one of the most common problems I see.

I've worked with manufacturers whose order books looked excellent. They had plenty of work and expected to make a good profit. Their customers, however, were paying on 60-day terms.

The manufacturers had to buy materials and pay employees, suppliers, rent, software and VAT before the customer money arrived.

Each new order looked profitable, but the business had to finance the work for two months.

Late payment stretches that gap further. A disputed invoice or a customer who never pays can turn expected income into a bad debt.

There's also a concentration risk. When one customer represents a large proportion of your income, a single late payment can affect the whole business.

Chasing payment can feel uncomfortable, especially when you value the relationship. I used to feel awkward about it myself. But you've completed the work and earned the money.

The key is to:

• invoice promptly

• state your terms clearly

• follow up as soon as a payment becomes overdue

Where the work is substantial, consider a deposit or staged payments so you aren't financing the full project yourself.

It can also help to grade regular customers according to how reliably they pay.

A customer who provides a lot of work but needs chasing for every invoice may be less valuable than the sales figure suggests.

Growth uses cash before it generates cash

Rapid growth catches many owners out because the business appears to be heading in the right direction.

A larger contract may require more stock, extra employees, subcontractors, equipment or extra space. Those costs often arrive before the customer makes their first payment.

This is sometimes called "overtrading". The business accepts more work than it can comfortably finance with the cash available.

The problem isn't necessarily that the new work is unprofitable. The business may earn a healthy margin once the contract is complete and paid. It still needs enough cash to reach that point.

Before you accept a major order, work out:

• what you must spend before the first payment arrives

• when the customer is contractually due to pay

• how long customers typically take to pay in practice

• whether you can still meet your existing commitments during the gap

• what happens if delivery costs rise or payment is delayed

Forecast the financial effect before signing the contract. Finding out that you need another £30,000 halfway through delivery leaves you with fewer and more expensive options.

Stock and unfinished work tie up money

Stock is cash in another form. Until you sell it and collect the customer's payment, you can't use that money to pay anything else.

If you're a growing product business, you may report stronger sales while buying stock at an even faster rate.

Some of that stock may sell quickly. Some may sit in storage, become obsolete or need to be discounted.

As a service business, you might have a similar issue with work in progress. Employees and subcontractors may spend weeks delivering a project before you reach an invoicing milestone.

Review how long stock sits in the business and how long work remains unbilled.

Smaller, more frequent stock purchases may release cash, although you'll need to balance that against price and supply risks.

For longer projects, agree invoicing points that reflect the cost of the work as it progresses.

Large purchases use cash faster than they reduce profit

Buying a van, machine or other major piece of equipment can take a large amount of cash out of the bank immediately.

In accounts prepared on an accruals basis, the full purchase price won't necessarily appear as an expense in the same period.

The asset may be recognised over its useful life through depreciation. That means cash can fall sharply while the effect on reported profit is spread across several years.

HMRC describes depreciation as a non-cash item and notes that replacing or upgrading assets creates a real cash cost for the business.

Plan significant purchases within your cash flow forecast. Consider whether the business can pay outright without weakening its working capital.

Leasing or asset finance may spread the cost, but compare the total cost and make sure the repayments remain affordable.

You mistake tax money for available cash

A large bank balance can give you a false sense of security when you already need part of it for VAT, PAYE, Corporation Tax or Self Assessment.

Business owners usually know these bills are coming. The problem is that the money remains in the main account and other costs gradually absorb it.

I prefer to treat tax as committed money. Transfer an appropriate amount into a separate account as income arrives and include every expected payment date in your cash forecast.

There isn't one percentage that will suit every business. Your VAT scheme, expenses, profit level and business structure all affect what you'll owe.

Ask your accountant or bookkeeper to help you set a realistic amount.

Loan repayments reduce cash

Loan repayments have a different effect on cash and profit.

The interest element is generally an expense. Repaying the amount you originally borrowed (known as the "principal") reduces your cash and the loan balance but doesn't reduce your reported profit in the same way.

A business can therefore make a profit while a sizeable monthly loan repayment continues to drain its bank account.

List the principal and interest separately in your planning. Check when fixed-rate agreements end and whether any large final payment is due.

A loan that once looked manageable may become a problem after other costs rise.

Money the owner takes out affects the bank balance

Sole traders and partners can withdraw money as drawings.

These withdrawals reduce the cash available to the business even though they aren't treated as ordinary operating expenses when calculating profit.

Limited company owners can receive money through salary, dividends, expenses or a director's loan. These have different accounting and tax treatments.

A dividend can only be paid from available profits, while money taken out that isn't salary, a dividend or an expense repayment may be treated as a director's loan.

Avoid deciding what you can withdraw simply by looking at today's bank balance. Check what you must pay over the coming weeks and agree a sustainable approach with your accountant.

The margin may be too small

Sometimes the business has a cash timing problem. Sometimes it isn't earning enough from the work.

Sales may be rising while supplier charges, delivery charges, discounts, refunds, overtime and overheads erode the margin. Your business feels busy because a lot of money is passing through it, but very little remains.

This isn't like chasing invoices, and needs a different response. Getting paid faster won't fix work that you've priced too cheaply.

Review the real cost of delivering each product, service or contract. Include the less obvious costs, such as rework, customer support, wasted materials and your own time.

When every sale generates only a small contribution towards overheads, increasing sales can create more activity without producing much cash.

There's no room for the unexpected

Even a well-run business will face costs that weren't in the plan.

Equipment might break down, or a customer might pay late. A supplier might change their terms. Or, a quiet period might last longer than you expected.

If you run a seasonal business, you're particularly exposed. You may be profitable across the full year but experience several months when more cash is going out than coming in.

A cash reserve gives you time to deal with these events sensibly.

The right amount depends on your fixed costs, customer payment patterns and how predictable your income is.

Start with a realistic target and build towards it rather than waiting for a month when there happens to be plenty left over.

4. Is it a cash flow problem or a profitability problem?

The distinction matters because the solutions are different.

• A temporary cash flow problem often has an identifiable cause around timing. Money from customers is due, cash is held in stock or a planned investment has lowered the bank balance.

  Once the relevant payment arrives or the stock sells, the position should recover.

• A profitability problem goes deeper than that. The business isn't generating enough income to cover the full cost of operating, even when customers pay on time.

With this in mind, ask yourself these questions:

• Are my products, services and contracts producing a worthwhile margin?

• Is cash mainly tied up in invoices, stock or unfinished work?

• Does the bank balance recover when customers pay?

• Are loan repayments, asset purchases or the withdrawals I make absorbing the difference?

• Does the business regularly need credit to meet ordinary costs even after expected income arrives?

Look at several months rather than one isolated week. Cash flow moves constantly and a short-term dip may be harmless. A repeated pattern deserves attention.

5. Warning signs that profit isn't turning into cash

Cash shortages tend to leave clues before the business reaches the point where it can't pay a bill.

Here are some of those clues:

• Revenue rising while the bank balance falls

• A growing total of overdue customer invoices

• Holding more money in stock

• The business relying regularly on an overdraft or credit card for normal expenses

• Suppliers chasing you more often

• Feeling concerned every time a VAT, payroll or tax payment approaches

• Delaying essential purchases because the money isn't available

• Using the next customer payment to cover commitments that are already overdue

• Not knowing what your likely bank balance will be in four weeks

One warning sign may have a straightforward explanation. Several appearing together usually indicate that the business needs a closer review.

6. How to stop a profitable business running out of cash

Build a rolling cash flow forecast

A cash flow forecast shows when you expect money to enter and leave the business.

Cover at least the next 12 or 13 weeks and update it as actual figures replace your estimates. Include realistic payment dates rather than assuming every customer will pay on the date the invoice is due.

Add wages, supplier payments, tax, loan repayments, subscriptions, rent and planned purchases. Include a cautious version showing what happens if an important customer pays late.

The forecast won't predict every event. It gives you enough warning to make decisions while you still have choices.

• Read our guide to creating a cash flow forecast and download our free cash flow forecast template.

Shorten the time between doing the work and receiving the money

Send invoices as soon as the relevant work or milestone is complete. Waiting until the end of the week or month delays every stage that follows.

Make payment terms clear before starting. Check that every invoice contains:

• the purchase order number

• contact details

• any supporting information the customer needs to approve it

Use deposits, retainers or staged billing where they fit the work. And stop treating credit control as an occasional admin task. Review outstanding invoices regularly and follow up consistently.

If a customer repeatedly fails to pay, consider whether continuing to work for them makes commercial sense.

Check your contract and get advice before suspending an active service or taking recovery action.

Manage the working capital cycle

Your working capital cycle is the time between paying for what you need to deliver a sale and collecting the customer's money.

You can shorten it by:

• reducing unnecessary stock

• invoicing earlier

• collecting deposits

• negotiating suitable terms with suppliers

• reviewing unfinished work regularly

• dealing with disputed invoices quickly

A few days saved at each stage can make a noticeable difference when your business processes a large number of orders.

Plan growth before committing to it

Before you take on extra work, forecast the cash you'll need for new employees, stock, equipment and premises.

Be honest about the delay between spending the money and receiving the return.

Funding can bridge a genuine timing gap in a healthy business, but it won't repair weak margins or continual losses.

Understand what's causing the shortage before taking on more debt.

Separate money that's already committed

Set aside tax and other predictable liabilities as you go. This makes the main bank balance a more realistic reflection of what your business can spend.

You may also find it useful to separate funds for wages, loan repayments and planned investment.

The purpose of the arrangement is to stop committed money being used accidentally.

Build a reserve deliberately

Decide how much financial breathing room your business needs and treat contributions to the reserve as part of the monthly plan.

You may need to start small. It's more important to be consistent than choosing an ambitious figure that the business can't sustain.

7. Trevor's weekly cash check

I reserve time each week to think about the business rather than simply doing client work. A basic cash check takes around 10 to 20 minutes and doesn't require expensive software.

Choose a regular day and review:

• your current bank balance

• reliable money you expect to come in during the next four weeks

• payments due during the same period

• VAT, PAYE, tax and loan payments approaching

• customer invoices that are overdue

• supplier invoices you haven't paid

• stock, equipment or other significant costs on the horizon

Use reliable income, not every invoice you hope might be paid.

If the money due to go out exceeds the cash you reasonably expect to receive, you've identified a gap. Work out when it appears, how large it becomes and what causes it.

You might be able to invoice earlier, collect an overdue debt, agree different timings with a supplier, postpone a discretionary purchase or take less in owner withdrawals.

Where it's appropriate to seek finance from outside, arranging it early will usually give you more options than applying once you're already missing payments.

8. When to get professional help

Speak to an accountant or qualified adviser if:

• you're repeatedly unable to pay suppliers on time

• payroll or HMRC payments are at risk

• you're borrowing more without resolving the cash shortage

• customers owe you a substantial amount

• you can't explain why cash keeps falling

• the business may be unable to meet its debts

Don't keep borrowing simply because the bank balance is low. Find out whether you have a temporary funding gap or an underlying profitability problem first.

If you run a limited company, the position becomes particularly serious if you can't pay bills when they fall due or your debts are worth more than your assets.

These are recognised tests of insolvency. Directors of an insolvent company have specific responsibilities towards creditors and should seek professional advice promptly.

An accountant can help you understand the figures. If there's a chance of the business becoming insolvent, speak to a licensed insolvency practitioner.

9. Don't wait for the bank balance to force the decision

Cash flow problems rarely arrive without warning. They develop as invoices age, stock accumulates, repayments leave the account and future bills get pushed out of mind.

Technology makes it easier to see what's happening.

Most accounting platforms and banking apps can provide up-to-date balances, debtor reports and forecasts. They only help when the records are current and somebody reviews them.

My advice is don't ever bury your head in the sand. You may find figures you don't like. Finding them early gives you time to act.

Review your cash regularly, chase the money you're owed and plan for the payments you know are coming.

Profit is important, but the business still needs enough cash to reach the point where that profit becomes money in the bank.

Profitability FAQs

Can a profitable business still fail?

Yes. A business can report a profit but still fail if it can't pay wages, suppliers, tax or other debts when they become due. This is known as a liquidity problem.

Is negative cash flow always a bad sign?

No. Cash may fall during a planned investment, a seasonal low period or a period of growth.

The business needs sufficient reserves or finance to cover the gap and a credible reason to expect the position to recover.

Repeated negative cash flow without a clear explanation is more concerning.

How often should I update a cash flow forecast?

Update it at least monthly when cash is stable. Review it each week when the business is growing quickly, customer payments are unpredictable or financial headroom is limited.

A short weekly check will help you spot changes between formal updates.

How much cash should a business keep in reserve?

There's no universal figure. Consider your monthly fixed costs, seasonal patterns, customer payment terms and the likelihood of unexpected expenses.

Set a target that reflects the risks in your business and build towards it steadily.

Should I borrow money to solve a cash flow problem?

Borrowing can help with a temporary and clearly understood funding gap. It adds repayments and interest to future cash outflows, so it can worsen a structural problem.

Prepare a forecast, understand why the cash is needed and make sure the business can afford the repayments under less favourable conditions.

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