11 May Profit vs Cash

Why do you pay tax when there is no money in the bank?

Most of us in business know the term “Cash is King”, but fewer of us know the difference between profit and cash.

As an accountant and business coach these two terms go hand in hand. There are certain activities that affect your cash, but not your profit and vice versa. So, what is the difference and why is it, that you pay tax when there is no money in the bank?

Let’s take a closer look at your profit. The profit is the figure your accountant assesses each financial year to calculate your income tax. Your profit is made up of your turnover, which is income only, less your deductible expenses such as bank fees, purchases, staff training, wages, accounting fees etc.

It is important to note that profit figures are exclusive of GST, if you are registered, because you are dealing with this tax type separately through your GST returns. In other words, your income tax is calculated on GST exclusive figures, so you don’t pay tax twice.

There are certain outgoings that do not affect your profit such as loan re-payments, asset purchases, tax payments, owners’ drawings, and dividends. Taking drawings out of the business affect your bank account, but not your profit. Re-paying a business loan is also not a deductible expense because you are reducing a liability in the balance sheet. The only portion deductible is the interest on the loan.

When purchasing a new asset, i.e. a new business vehicle, it does not affect your profit because you are increasing your business assets. The only portion deductible here is the depreciation amount. Dividends are paid from after tax profits.

On the flip side there are transactions that affect your profit, but not your bank account such as depreciation, end of year adjustments, i.e. home office, shareholder salaries allocation and other book entries created by your accountant when preparing your financial accounts and tax returns.

Whilst you don’t necessarily need to know all the in’s and out’s of what your accountant does, you do need to know your cash position and understand the impact of your spending habits on your business’ affairs.

Here are 5 main areas to consider when preparing a cash flow forecast

• Business Income (exclusive of GST*)
• Business Expenses (exclusive of GST*)
• Tax Payments (GST, Income Tax, FBT)
• Capital Expenditure (Assets, Loan Repayments, Loan Advances, Credit Cards)
• Personal Expenditure (Drawings, Other Personal Spending)

*for GST registered entities only.

The timing of each is crucial to understand when you may need a temporary overdraft facility or increase your prices if your overall cash position is negative. It is a great tool to identify unnecessary spending and brings awareness to overheads that may need to be reviewed or re-negotiated.

For more information and assistance please get in touch with us. We are here to help to make the process as easy as possible for you.