The Imaginary Profit Loop

Have you ever wondered why the "profit" which you pay tax on year after year never seems to arrive in your bank account? Do you listen to your accountant explaining the amazing year that you apparently just had, but all you can think about is how you'll find the money to pay the tax bill on this 'amazing' profit? The accounts say you made a profit, Revenue say you owe tax, and you say I haven't got it, does this sound familiar? Today, lets cut through the nonsense and explain the logic behind this confusion, how to better manage it, and why ignoring it can be a death sentence for your business.

What is Profit?

Everyone wants to be profitable, that's the reason you're in business in the first place, but it's important to understand exactly what profit is first. Profit is essentially the result of an accounting exercise which was designed for huge corporations handling tens of millions on a daily basis. It's computed by subtracting your trading expenses incurred from sales invoiced on an accrual basis, so not on what's lodged, but on what's billed. There are also many payments which don't qualify as expenses to be taken from your profit, I'll go through some common ones a bit later, but essentially, the profit figure the accountant gives you each year is worked out for Revenue and the CRO, not for you. It is not necessarily a reflection of your business at all, and it's imperative that you understand this, because otherwise it can send a small business into a tailspin.

The Imaginary Profit Loop

This loop is something catastrophic I've noticed over the years, and one of the main reasons I started the firm was to try help small business owners avoid it. As we mentioned above, your taxable profit can be different from your cashflow in any given year. That's fine, but the real issue comes when the two figures are so far apart that you can't seem to afford the tax bill at the end of the year. For example, you might have €30,000 profit, owe €12,000 in tax, but have €25,000 already spend on a loan repayment, VAT, and tied up in debtors. You ask your accountant what is going on, and he says something like 'it's just the timing of it', 'the profit is there', or 'you must have spent it somewhere else'. None of these vague statements actually address the issue, and the only solution you can deduce is you need to work harder and make more money to pay this tax bill. You can probably see where I'm going with this; you push on and gather together what's needed for Revenue, he gets paid, and you think you can relax. Now though, at the end of the next year, this extra effort you put in created an even higher "profit", and therefore higher tax bill. Since the original cashflow vs profit issue was never addressed, you now again don't have the money to pay the even higher bill. The accountant again says, "that's just how it works", he might even praise your "exceptional growth", and the cycle begins again. You can't see what is going wrong, and you can't escape either because each increasing tax bill needs to be paid. I have seen business owners stuck on this hamster wheel for decades, constantly pushing to the limit, and never seeming to get ahead. The worst part is, they have absolutely no idea that somethings wrong, and their accountant isn't trained or equipped to advise them, they're snowed under dealing with Revenue and trying to get everyone's tax filed on time.

Your Business Actually Needs 3 Things

Don't get me wrong, every business needs to make a profit in order to stay alive, but it needs more than that. I've worked out that there are three factors which keep your business alive, same as a person, and these are Profit, Process, and Payments (Cashflow). Profit is like food for your body, you can't survive without it, but the other two are actually even more important. Your Process is the physical running of the business, day to day. This is like the heartbeat of the business, and it's what most small business owners do exceptionally well, it's what makes them tick. The phone ringing, work getting done, orders being shipped, fighting fires, everything you do to keep your customers happy on a daily basis. Without this heartbeat, your business won't stay going for long. Most small businesses stop here. They have profit on paper. Their Process is good. And now they can't understand why they're not thriving. The issue is, like your body, your business needs three things to survive. Now, it has food and a heartbeat, but without Payments (Cashflow), your business has no oxygen. It can be the most profitable and best managed business in the world, but without solid a solid Cashflow, your business will suffocate.

How to Escape

The best thing about all this is a cashflow issue can be fixed. That difference between profit and cashflow is an accounting management issue, and fixing the problem is as simple as getting some good advice from an accountant who understands the realities of small business. The main cashflow leaks are loan payments, capital purchases from cashflow, debtors, stock, personal expenses, and VAT. These are all causes of a discrepancy between your net profit and cashflow. I always say to my clients that usually as soon as an issue becomes visible, it somehow solves itself. In most cases, if you can quantify these leaks and adjust your 'profit' to a figure that more accurately reflects your performance, what you need to do becomes obvious.

Cashflow issues like this won't be fixed overnight, but by putting one foot in front of the other and making steps in the right direction, you can create a business which puts money in your pocket without taking your every waking moment. One client I worked with had been stuck in this loop for almost a century, and within 5 years we managed to turn it into a business that works for the owners, not the other way around. If you'd like to take the first step to breaking free from your cashflow nightmare, click here to download a template and within 15 minutes, you'll know exactly where your profit is going, and what to fix first.

Thank you for taking the time to read, and I hope it has been of value. If you'd like to get in touch with any questions, or to learn more about the Imaginary Profit Loop, please do not hesitate to leave a comment, or reach out to us at info@jesinnott.ie.

Be advised that the information provided in this blog post is for general informational purposes only and does not constitute legal or tax advice. While we strive to ensure the accuracy and completeness of the content, it should not be relied upon as a substitute for advice tailored to your specific situation. We are happy to provide this should you require assistance on any of the matters outlined above.