Your Profit & Loss Is Lying To You (Trade & Construction Cash Flow Training)

One of the most common mistakes that I see trade business owners making when it comes to understanding their financials and trying to make more money in their business is actually making decisions solely based off what they see on their profit and loss statement.

Which might sound really counterintuitive...

But in this article I’m going to break down exactly what I mean by this and exactly what NOT to do with your profit and loss statement if you are running a trade business, and you want to make more money.

First things first...

Reset your thinking:

If you want to earn more money, you do not want more profit.

You actually want more cash!

Because profit can be distorted; the profit and loss and even your balance sheet can be distorted... the only real fact in your business is cash!

Cash is what is left over for you to enjoy after everything else has happened.

So, this means to earn more money; you need to know how to earn more cash.

Which is why you cannot make decisions solely based off what your profit and loss statement is telling you - because the profit and loss actually tells you nothing about cash.

Often times cash comes in, cash goes out, and business owners are left wondering why the profit on their P & L doesn’t reflect what’s actually in their bank account, because they’re looking at what is called paper-based profit… NOT cash in the bank.

And one of my favourite sayings is...

 "Revenue is vanity, profit is sanity, cash is reality"

There’s a massive, MASSIVE difference between profit, and cash.

Profit is the result of your profit & loss statement, cash is the result of your business.

The profit and loss won’t tell you how your business is really going – because there just isn’t enough information.

All it gives you is the sales you’ve made minus the expenses you’ve incurred and the paper profit that’s left over.

Nothing about assets purchased, how much money you’re owed, when you’re paying suppliers, works in progress, director loans and so on… which all have a real dollar cost attached to them that effect cash.

To get the full picture of your business (and your money), you also need to understand your balance sheet.

Now for many business owners that I speak with, the balance sheet tends to come across as more complicated than the profit and loss. But you have to understand it… because profit on paper doesn’t pay bills, cash does!

So, i'll make this really simple.

If you want to earn more money, you need to make more cash, and to understand your cash, you really need to see it as a story that is told over 4 chapters.

Net Profit - Working Capital Invested - Other Capital Invested = Cash

Now if you’re not quite sure what this means, bear with me, I’ll break it down one step at a time… starting with chapter one.

Chapter one is Net Profit.

The profit your business makes after every cost has been factored in, which is the figure sitting at the bottom of your profit and loss statement.

This is where I see most trade business owners living, typically using the profit and loss as their way of understanding the health of their business.

But if this is you, and you are living only in chapter one, then I promise you that your profit and loss is lying to you - And here’s why...

Understanding the cash in your business is just like reading a murder mystery.

You cannot read chapter one of the book and then jus t expect to uncover who the murderer is (that’s all discussed at the end), if you want to know what’s really going on, you have to read the whole story.

And the same is true for Cash!

You need to read all 4 chapters – not just chapter one, net profit.

Net profit, minus working capital, minus other capital, equals cash.

Revenue might be growing, margins might be up, profit could be increasing – but this does not tell you how much cash you’ve made…

And to prove this, I’ll run you through an example of a TBA client that for privacy reasons I’ve re-named to ABC plumbing.

In the year prior to working with us, they had grown revenue by 17% from 3.5 to 4.2M, operating profit by 19% from $375,000 to $462,000 and net profit by 21%, going from $165,000 to $208,000.

Which from a profit and loss, chapter one perspective, looks great right?

Business is great... right!?

But looking at these financials from a cash perspective, not just paper profit... how did they go? How much cash was made?

Well despite what the profit and loss was telling them, they actually LOST NEGATIVE $326,000 in cash…

Here's why...

Chapter one net profit in this instance, was $208,302, which is found at the bottom of the profit and loss.

And looking back at the 4 chapters, this is where it sits in the equation.

You can also see that it’s sitting in the left-hand column that positively effects cash flow.

This is because increases in profitability have a positive effect on the cash flow of your business.

The more profit you make, assuming you’re collecting all of it, the more cash you’ll generate in your business.

We now look at chapter two.

Chapter two is working capital invested.

The next chapter we need to look at… is chapter two, working capital invested.

Working capital is simply the amount of cash needed to run your business over the short-term.

And this is where the balance sheet now comes in.

There’s a lot going on here, but out of everything listed in the balance sheet, there are only three lines that you need to worry about when it comes to working capital:

1. Accounts receivables

2. Works in progress (WIP) or Stock

3. Accounts payable

Your accounts receivables is just a fancy word accountants like to use to explain the money owed to you from your customers.

Your WIP or works in progress are the work you’ve done at your expense that you’ve not yet invoiced for.

Your stock is similar to this, it’s just the supplies you have on hand that are waiting to be allocated to a job, to then be invoiced.

And then finally, there’s your accounts payable, which is the money you owe to your suppliers.

These three-line items are known as Working Capital because they determine the amount of cash needed to run your business over the short-term. And they largely dictate the cash coming in and cash going out of your business.

Now, for chapter two, we want to we want to calculate the working capital invested this year on top of last year because this will show us if the profit made this year was used to fund any increase in working capital from the year before.

To do this, the formula is:

Difference in accounts receivable (that is the difference between 2020 sand 2021), plus the difference in WIP or Stock, minus the difference in accounts payable, equals the working capital invested.

So, if we look back at our balance sheet:

Accounts receivable has increased $191,781.

That is $863,014 minus $671,233 equals $191,781.

WIP or stock has increased by $395,455.

And accounts payable has increased by $152,926.

That means, all up, the business has invested an extra $434,310 in working capital in 2021 compared to 2020.

So, looking back at the 4 chapters again, this is where Working Capital Invested sits in the equation:

Now, you can see here that it’s sitting in the right-hand column that negatively effects cash flow.

This is because the more working capital, the more cash your business needs to fund operations.

Once we know the total increase in working capital, we then arrive at chapter three.

Chapter three is other capital.

To make the balance sheet simple, anything outside of working capital, we just call other capital.

These are complicated accounting terms like accruals, repayments, provisions, deferred tax, other current assets, and liabilities and so on…

But they have little to do with the management of your business – so don’t worry too much about those, leave that for your accountant and just group them as other capital.

To calculate other capital, we again need to look at the balance sheet.

Here, we look at difference in equity, plus difference in debt.

Equity is the value that would be returned to shareholders if all assets were sold and all of the company's debts were paid off.

Debt represents the value in a business that is owed to creditors like banks.

The combination of these two represents the total increase in funding, or capital, in the business in 2021, that was used to fund the increasing cost of operations in 2021.

So, by subtracting the working capital figure from this total, we can calculate the leftover, which is other capital invested in 2021.

All up, the formula for other capital looks like this:

Difference in Equity, plus the difference in Debt, minus the Working Capital Invested, equals the other capital invested.

So, looking at the balance sheet:

Equity has increased by $208,302.

The combination of short term and long-term debt has increased by $326,007.

That means, all up, once we subtract the working capital amount of $434,310, the business has invested an extra $100,000 in other capital in 2021.

So, looking back at the 4 chapters again, this is where Other Capital Invested sits in the equation:

Now, you can see here, it’s also sitting in the right-hand column, negatively effecting cash flow.

This is because, like working capital, the more you invest in other capital, the more cash that is getting drained from your bank account.

Which brings us to the final chapter of our story.

Chapter four is cash.

The result of your business… Cash. What really matters.

The money left over after everything else has happened.

To calculate Cash, we now just revisit our original formula:

In this example, as I said, after making $208,302 in Net Profit, ABC Plumbing had actually lost $326,000 in cash.

Which hopefully proves just how important understanding the entire story of your numbers is.

If this client were to continue just living in their profit and loss statement and focusing on what chapter one was telling them, they would have been fooled into thinking that business was great.

And they wouldn’t have known where all their money was going and things could have gotten much, much worse.

So, while chapter one, net profit, in this case was up $208K… we needed to read the entire story to get the full picture of their cash and how much they were earning.

Cash is what matters most in business. 

You cannot afford to only make decisions based off what you see on your profit and loss statement because it’s only one chapter in the four-chapter story of your numbers.

If you get your head around this, it will change the way you operate forever.

Now, if you’d like to see more on this topic, I’ve just launched a brand-new masterclass where I take the time to run through exactly how all of this works in step-by-step detail, with real client case studies, and I also give a whole bunch of actionable strategies that you can use to skyrocket the cash in your business pretty much straight away…

And there’s even a bunch of exclusive free bonuses:

If this interests you CLICK HERE TO LEARN MORE.

If you're an electrician, plumber, painter, carpenter, or any other tradie business owner turning more than $1M a year looking for assistance with your tax, accounting, bookkeeping, and business advisory - click here to learn more!