Profit vs Cash: Why Xero Accounts Don't Match Your Bank Balance

Xero says you've made £100,000 profit this year, but your bank account has £30,000 in it. So, where's the other £70,000?

Clients have asked us questions like this a few times. Your accounting software says you’re making big money, but your bank account disagrees. To make matters worse, you’re about to be asked for Corporation Tax on profit you can’t actually see!

This isn’t usually a discrepancy. Many business owners assume profit and cash should move together. In reality, they often don't.

However, sometimes the profit figure actually is wrong, and you may end up paying tax on money you haven’t earned yet.

Profit and cash measure different things

In simple terms, profit is what you earned in a period, minus what it cost you to earn it. Your bank balance will show you when this money actually moved.

Limited companies keep their books on an “accruals” basis. This means income is counted when you earn it, not when the customer pays. Likewise, costs are counted when you incur them, not when you actually pay the bill. That accruals profit is the starting point for your Corporation Tax bill.

This is why your profit and cash levels can sometimes look out of sync. The key question to ask is: has income been counted in the right reporting period?  

Why do profit and cash usually differ?

• Customers haven’t paid you yet: The profit exists, but the cash doesn’t (yet)
• You’ve bought assets or repaid debt. Cash has left the business; profit barely changes.
• You’ve received money in advance. The cash exists but profit shouldn’t yet.

Knowing the terms

Let’s use an example to explain these key terms. For this example, you own a premium gym and health club that sells a year’s membership for £1,200, paid up front in January.

• Deferred income: Imagine someone pays your gym £1,200 today for 12 months' membership. You now have £1,200 in the bank, but you haven't earned £1,200 yet. You've only earned the first month’s worth.
• Accrued income: This is the same principle, but in reverse. The business has done the work but hasn’t invoiced for it yet. It counts as income now, even if the cash arrives later on.
• Prepayments: These are costs that are paid for in advance, such as annual software licences or insurance policies. Spread them over the months they cover.
• Accrued expenses: These are costs that the business incurs but has not been billed for yet, such as a December electricity bill that arrives in January if your year-end is 31 December.

Do you pay tax on upfront payments right away?

For a limited company, you usually do not pay tax on upfront payments right away. Corporation Tax is based on the profit you earned that year, so you shouldn’t include income you haven’t earned yet. Here are a few more examples:

• Annual subscriptions: Only the months you’ve delivered by your year-end count as this year’s income.
• Deposits: These are generally deferred until you do the actual work they relate to. VAT, however, is different and is normally due when you receive the deposit (unless it's a refundable security deposit).
• Grants: These are a little more complex and depend largely upon the terms. Many grants are recognised as you meet their conditions or incur the costs that they are there to fund.

Deferring income defers the tax

Deferring income also defers the tax associated with that income. It does not cancel it. You will just pay tax on the income in the year you earn it.

What about sole traders?

For sole traders, things are a little different. If you’re a sole trader on the cash basis (the default since April 2024), income is generally taxed when you receive it.

Ring-fencing income in your books

Ring-fencing income stops you paying Corporation Tax on money you haven’t earned yet. This, in turn, keeps your profit figure honest for making decisions, or for lenders or valuers. Until you deliver, you still owe the customer the work, and may owe a refund if you can't deliver.

Ring-fencing takes place in your books, not by moving money between bank accounts. You can code up-front invoices to a deferred income account (a liability), and then release them to sales when you deliver. Each month, you just need to move the part you’ve earned from liability to income.

Using our previous example, a £1,200 annual contract becomes £100 of monthly income. That means if it starts three months before your year-end, only £300 counts towards this year’s profit.

Xero, QuickBooks, FreeAgent and Sage all let you set this up with a liability account and manual journals

Ring-fencing the cash for tax purposes

Separately from ring-fencing income, you should also ring-fence the cash itself. Put money for Corporation Tax and VAT into an easy access savings account every month. This prevents the bill from coming out of your working capital (and can provide a modest bonus).  

So how could £100k profit mean only £30k in the bank?

Here’s another example, based on a SaaS (Software as a Service) company with a 31^st March year-end. In March, it invoiced and collected £40,000 of annual subscriptions for the following April to March period. This was coded straight to sales.

Moving that £40,000 to deferred income instead reduces profit from £100,000 to £60,000. As a result, this year’s Corporation Tax falls from approx. £22,750 to £12,150. That income is taxed next year instead, as the service is delivered.

Worked example

Let's start with £60,000 of genuine profit.

Add £40,000 of subscription cash received in advance.

Then deduct:

• £30,000 of invoices customers haven't paid

• £25,000 of dividends

• £10,000 of equipment purchases

• £8,000 of loan repayments

Add £3,000 of VAT you're temporarily holding.

That gives you a bank balance of roughly £30,000.

_{Illustrative figures: Corporation tax rates for the year to 31 March 2027 with marginal relief, a single company, a 12-month period, no other adjustments, and a bank balance of £0 at the start of the year.}

As you can see, none of these items is a mistake. Dividends, loan repayments and equipment costs all take cash out of the bank, but either aren't costs at all (dividends, loan repayments) or are spread over several years (equipment).

How to check your profit is right before year-end

Most businesses don't have a problem with Xero. They actually have a problem with how it’s been configured. If you don't review deferred income, prepayments, and year-end adjustments regularly, your management accounts can become misleading, leading to poor decisions and unexpected tax bills.

Here are some checks you or your accountant can make to ensure your profit figures are correct before year-end, therefore preventing unwanted tax surprises.

1. Are annual or upfront invoices posted to a sales code, with the unearned portion then moved to deferred income by journal?
2. Is that deferred income released back to sales each month by journal?
3. Is work you've done but not yet invoiced included in income?
4. Are large bills paid in advance spread over the months they cover?
5. Is cash for Corporation Tax and VAT set aside each month?

If your answer to any of these is “no”, then your profit, tax bill or cash planning may be off.

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At Gravitate, we help our clients get on top of their numbers for a clear, accurate picture of their business performance all year-round, not just at the year-end. If you’d like to learn more about our approach, you can download our 12 Months of Smarter Accounting guide.