Imagine this, you have all your bookkeeping up to date, you have reconciled everything and you have pulled up a Profit and Loss report. It tells you that you have made a Profit, but you don’t believe that is right, where has all the money gone? If you had made a profit surely you would have money right?
Where has all the money gone? Or I haven’t made a Profit I have no money! Are very common statements I have heard from my clients over the years, upon them receiving a copy of their Profit and Loss Statement. I have even had some burst into tears and sob because surely the it isn’t correct; surely I have made a mistake.
What they don’t realise is that the Profit and Loss Statement is only part of the information. You need to also look at the Balance Sheet to understand where your money is. Earning a profit is only the first step in business. The profit is then used to pay off loans or purchase assets or used by the owners as personal drawings, so if you have had a great year paying down loans, buying new machinery or using a ‘bit’ of business money, then that is where your money has gone.
So lets look at this in more detail.
Purchasing of an Asset
Before the $20,000 instant write off law was introduced, if you purchased any piece of equipment that was valued at more than $1,000 then this was classed as an Asset, not an expense and is depreciated over time, not written off at the time of purchase.
$1,000 isn’t very much, most computers are worth more than that and some printer/copier/scanner machines are worth more than that. Even toolboxes with tools in them are worth more.
So as you can see, you may have paid cash for a piece of machinery that you thought was an expense on your Profit and Loss but in actual fact it is on your Balance Sheet as an Asset. Therefore you have used your ‘profit’ to make the purchase and it comes off your profit in your Cash Flow Statement.
You have still used ‘cash’ to purchase the piece of equipment, but it isn’t included on your Profit and Loss Statement.
Paying of a Loan
When you purchase an asset (Machinery, Motor Vehicle, Building etc.) and you borrow money to do so, then the portion of the loan payment that is the principal amount actually comes off the loan and is not classed as an expense.
Lets take a step back. You purchase a piece of machinery for $50,000. You don’t have $50,000 so you borrow the money from your bank. The loan is for $50,000 at a fixed rate of 8% for a period of 7 years.
Machinery (Asset) $50,000
Borrowing Amount (Principal) $50,000
Interest (8%) (Expense) $20,980
Total Amount Borrowed (Liability) $70,980
There will also be bank costs for setting up the loan as well, but these are expenses and therefore go straight into the Profit and Loss Statement.
When you make a payment onto the loan (in this example the repayment amount is $195.00 per week) a portion of the payment is interest and another portion is principal payment.
For this example the repayment amount is the same for each payment as it is a fixed rate of interest. If it was a variable rate then the amount that is principal and interest for each payment would change.
We have taken out a 7 year loan, therefore there are 364 payments to be made, all for $195 (assuming they are paid weekly).
Payment amount $195
Amount to come off Principal $137.36
Amount to be allocated to Interest $57.64
Each time a payment is made $137.36 comes off the principal in the balance sheet and $57.64 is allocated to an expense in the Profit and Loss Statement. It is a little more complicated than this, but the effect is the same. The principal payment reduces the amount of the loan in the Balance Sheet and the interest expense is allocated to the Profit and Loss Statement, therefore one is before the profit is made and one is paid with the profit.
There are various types of loans you can get so the calculations will change a bit but the information is basically the same.
Some Small Business Owners don’t realise how much money they take from their business either, so when they look at how much has been allocated to ‘Personal Drawings’ their first reaction is to deny they have have taken that much or try to explain some of the purchases as business ones.
A lot of Small Business Owners don’t take a wage from the business, but they still have to live, so $100 here and $100 there ‘wont affect much’, is usually their attitude, but they don’t realise that this money comes from their profit.
So even though their Profit and Loss Statement says the business has made a profit, it is quite often the case that this does not mean they are cash flow positive, as all their profit is used to pay back loans, purchase assets or become personal drawings for the owner.
This is why it s a good idea to have an understanding of this so that when you look at your profit and loss, you know that the figure down the bottom saying you have made a profit, is actually the money you have used to pay your loans, buy assets or to live on.