Why you can never judge a business by its profits

Craig Alexander Rattray is a Growth Strategist and Cash Flow Expert based in Glasgow, Scotland. He is the author of Mastering Cash Flow for Business Owners.

The UK government has announced a consultation into the future of auditing, in an attempt to avoid major collapses like BHS, Carillion, Thomas Cook and Patisserie Valerie.

There are various proposals that Business Secretary Kwasi Kwarteng believes will assist in not just "restoring business confidence" but also "people’s confidence in business".

That’s a lot of confidence that needs to be restored. But will it make a difference?

The real issue with auditing

For me, the key point is not whether the Big Four have a dominant market share, or are unduly influenced by fees and retaining clients.

Various high-profile collapses have occurred over the years, some not long after audited accounts were signed off, and I expect that will continue.

Why? The focus is wrong. We spend too much time looking back and not forward. We focus on profit rather than cash.

Yes, the audit should address the working capital needs of the business for the next 12 months, but how much focus is placed on that? How much work is done on interrogating the forecasts and looking closely at the cash flow assumptions?

Many business owners realise at some stage that the profit they make in the business does not equal their cash flow.

Even profitable businesses cannot survive without cash – it’s the oxygen a business needs to stay alive.

Tackling the expectations gap

We should remember the saying “revenue is vanity, profit is sanity and cash flow is reality”. It is true.

There is an expectations gap with respect to what an audit provides.

The fundamental purpose of the audit is to provide independent assurance that the accounts present a “true and fair” view of a company’s financial performance and position.

Some of that can be subjective and may include aggressive and judgemental accounting treatments, which can be used to artificially inflate profitability.

If we look at some high-profile collapses, what were the causes?

1. Aggressive accounting treatments, especially with respect to work-in-progress/long-term contracts/stock, goodwill impairment, and recoverability of sums due. Such aggressive accounting allows profits to be kept artificially high, thereby allowing dividend payments to continue and indeed to increase.

2. Paying dividends out of cash not generated from operations. Carillion paid £376 million in dividends over a five-year period in which it made only £159 million in net cash from operations.

3. A broken business model – no longer profitable and cash generative. In the case of Thomas Cook, think of the move by consumers from physically going to stores to booking online.

4. For me, the most important cause is the failure to focus on cash. There are numerous accounting treatments and tricks that can be used to keep profits high. However, one thing that is usually 100% correct is the bank position.

Taking action with your own company

If we focused on looking forward and on cash rather than manipulating profits, many of these collapses could be prevented.

This is where business owners should focus.

Sometimes these problems are due to funding growth and an increase in the working capital requirement.

However, sometimes the cash situation is down to manipulation of profitability, in an attempt to “window dress” accounts and keep banks and investors happy.

This generally only lasts for a short period of time, as eventually reality bites and the cash issues and mismatch with reported profit comes to light.

What lessons can business owners learn from this? Focus on cash, not profit.

How to retrain your mindset

Yes, we want to have profitable businesses and we need to understand profitability.

We must understand the cash flow dynamics of the business based on its strategic plan, and ensure that it makes both commercial sense and that it fits with the operational side of the business.

I have met many business owners who tell me that the numbers do not make sense and do not equate with what the business is doing. That gap shouldn’t exist.

Excellent financial management is about understanding:

• where you are
• where you have been
• where you are going?

This is done by having:

• current management accounts and information, plus an up-to-date bank position – "where you are"
• historic management accounts and full year final accounts – "where you have been"
• forecasts comprising monthly profit and loss, balance sheet and cash flow as well as a weekly rolling cash flow forecast – "where you are going?"

A business owner must understand the financial position and ensure that it fits with his opinion of how the business is trading operationally.

If not, questions must be asked so that there is a clear understanding of where the cash is going.

"Revenue is vanity, profit is sanity and cash flow is reality." Some things just deserve to be repeated.