When you run a small business, cash flow is critical – according to recent figures [1], 40% of small businesses have seen their growth restricted because of cash flow problems, while 31% have been unable to take on new projects for the same reason.
Being knowledgeable on the difference between cash and accrual business accounting, and adopting the right model for your business, can make a huge difference to your business cash flow.
“Understanding how accounting models can improve your cash flow means your business is in a better place to grow,” says Clare Bowen, a director at independent accountancy firm, MHA Monahans.
What’s the difference between cash and accrual accounting?
The key difference between the two accounting approaches is the timing of when a company registers its income and expenses.
With cash accounting, outgoing and incoming funds are recorded the moment they are either spent or received. With accrual accounting, outgoing and incoming funds are recorded when an invoice is sent or received, even if no money has yet changed hands.
When is cash basis accounting used?
Before exploring either approach in detail, it's important to note that not all UK businesses can use cash basis accounting. For example, it can't be used by limited companies, those with a business turnover of more than £150,000, as well as a number of other conditions listed on HMRC [2]. However, as this article will explore, it can still be used by many businesses in combination with accrual accounting, which has benefits for cash flow.
The key advantage of cash basis accounting is that it gives a business a clear view of its day-to-day cash levels. Co-founder and Director of UK-based PR and communications consultancy Round Earth Consulting, Sarah Lafferty, says: "We typically work with large companies in the technology sector, who often have long payment terms."
“As a small business, we can’t realistically set our own payment terms, so we might invoice a customer and be paid 60 days later, in some cases,” she says. “Using cash accounting means we can see what cash we have available in real-time. Because I have that information readily available, I was recently able to save 50% on our business insurance payments.”
Lafferty adds, however, that business owners should always take expert advice from their accountant on whether cash basis accounting is suitable for their business. “The information on the HMRC website is very complex, so we work closely with accounting advisors to help us understand what works best for our business and industry.”
Advantages and disadvantages of cash basis accounting
The key advantages of using cash basis accounting include:
- It allows small businesses to know how much cash is available to them in real-time.
- Cash accounting can make it easier to calculate your tax liabilities.
The potential disadvantages of cash basis accounting are:
- Your business might look profitable, but only because you haven’t met liabilities.
- Cash accounting provides a snapshot of your cash position today but can’t show you trends or likely future profits/cash flow.
When is accrual accounting used?
Accrual accounting means a company will record income when it raises an invoice or sends a bill to a customer. It will record expenses and liabilities when a bill is received.
Although accrual accounting is more complex, the introduction of HMRC's Making Tax Digital scheme [3] – which is intended to simplify tax for businesses – means most companies are now using accredited accounting platforms that will easily make the necessary calculations for you, says Bowen.
Snap It, a plumbing supplies company based in London, acts as an intermediary between plumbing merchants and tradesmen looking for spare parts and plumbing supplies. Snap It uses accrual accounting primarily because its turnover is too high to qualify for cash accounting. But with a high volume of payments in and out of the company, and large variation in payment terms, accrual accounting allows the company to track its outstanding revenues and liabilities more clearly.
Advantages and disadvantages of accrual accounting
As Snap It has found, accrual accounting provides a more detailed, rounded view of a company’s finances. By capturing income and expenses at the point they are generated and not when money changes hands, a business owner can see what’s coming down the track, says Bowen. “Accrual accounting is essential if you want to understand what you owe, who owes you, and what that means for your future cash flow.
“Having that longer visibility means you can make decisions about your future with more confidence. You know, for example, that you’re expecting £20,000 in income over the next month so you can afford to take on a new project,” Bowen says.
There are potential downsides to accrual accounting, such as:
- It can be more complex and means accounting is more time-consuming and expensive.
- You will have to pay tax or VAT on income that you might not have received, and it can be time-consuming to reclaim this if a customer fails to pay their invoice.
Paying tax and VAT before receiving the income they relate to can put a strain on cash flow. By using your American Express® Business Gold Card to make these payments, via a third-party service such as Billhop, you have up to 54 days to pay it off¹, helping you to avoid undue financial strain on your business.
The benefits of using a hybrid model
The rules over accounting in the UK mean that any registered company with a turnover of more than £150,000 must file accounts on an accrual basis. However, if its VAT-taxable turnover is less than £1.35 million, then it can still file VAT accounts on a cash basis.
Adopting this hybrid accounting model is common for small businesses that want to maximise cash flow, says Clare Bowen.
To illustrate the benefits, Bowen gives the example of a property maintenance company that purchases a large stock of materials from a hardware supplier at the beginning of the month, to complete a new project. The company spends £5,000 on materials, including £800+ of VAT, and invoices its customer £5,000 plus £1,000 VAT.
With accrual accounting, the company files a VAT return that requires payment of the £1,000 VAT on the new contract, even though the job might take two weeks to complete, and payment might not be received for 30 days after completion. In effect, the company has to pay the £800 VAT on its own expenditure, plus £1,000 on its future income.
“For a small company that can be a big hit," says Bowen. "If you’re in a business where there is a gap between invoicing and receiving payment, and cash flow is at a premium because you need to fund essential business expenses, then cash accounting for VAT is a useful option.
Using the above example, if the property company adopts cash accounting for its VAT returns, then while it will still need to pay the £800 VAT on the materials purchase, the £1,000 VAT payable on its invoice to the customer will only become due after the customer has paid.
The hybrid model of accounting is just one way that small businesses can manage their business expenses; paying for those expenses with an American Express Business Gold Card can help too. Each time you spend £1 on your Gold Card, you'll earn 1 Membership Rewards® point², which can be redeemed as statement credit to offset your expenses.
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
Sources
[1] Quickbooks, Small business, payments and cash flow 2021
[2] HMRC, Cash basis
