Fern & Co.: Correcting the Profit and Chasing the Debtors
Fern & Co. is a garden maintenance business run by Aoife as a sole trader; her year end is 31 December. Her bookkeeper produced this summary for the year just ended, in euro: cash sales 48,000; credit sales 36,000; opening stock 3,200; purchases 41,000; closing stock 4,100; wages 19,500; rent 7,200; van running costs 5,400; loan interest 900; debtors 9,000; creditors 4,500.
Two errors have since come to light. First, Aoife took €4,000 out of the business during the year and the bookkeeper put the whole amount through the wages account. Second, a €2,400 van repair was debited to the Van account, which is treated as a fixed asset, instead of to expenses.
The bookkeeper's draft accounts show a net profit of €10,900, and Aoife cannot understand why her bank balance fell by €1,800 over the same period.
1. Calculate the corrected gross profit and net profit, showing the effect of each correction. Explain the accounting reason for each adjustment.
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Gross profit
Cost of goods sold = opening stock €3,200 + purchases €41,000 − closing stock €4,100 = €40,100 Gross profit = (€48,000 + €36,000) − €40,100 = €84,000 − €40,100 = €43,900
Neither error affects gross profit: drawings are not a purchase, and a van repair is not stock.
Correction 1 - drawings of €4,000 in the wages account. Drawings are the owner taking out profit she has already earned. They are not a cost of running the business; profit is measured before drawings. Correct wages = €19,500 − €4,000 = €15,500, so expenses fall by €4,000. The €4,000 is deducted from capital instead, as a separate item in the capital account.
Correction 2 - €2,400 van repair capitalised. The repair restores the van to the condition it was already in; it does not add a new asset or extend its useful life. That makes it revenue expenditure and it belongs in the profit and loss account. Expenses rise by €2,400, and the van's book value is €2,400 lower than the draft balance sheet shows.
Corrected expenses: €15,500 + €7,200 + (€5,400 + €2,400) + €900 = €31,400
Corrected net profit = €43,900 − €31,400 = €12,500
Check: €10,900 + €4,000 − €2,400 = €12,500 ✓
If Aoife asks 'what did I earn?', the answer is €12,500. If she asks 'what did I keep?', it is €8,500 after €4,000 of drawings.
2. Using the debtor and creditor figures, explain why the bank balance fell by €1,800 even though the business made a profit. Support your answer with calculations.
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The working capital gap
- Debtor days = €9,000 ÷ €36,000 × 365 = 91 days
- Creditor days = €4,500 ÷ €41,000 × 365 = 40 days
Aoife waits about three months to be paid by her credit customers but pays her suppliers in about five weeks. That 51-day gap has to be funded from somewhere, and the only somewhere is her own bank account.
Why profit and cash diverge. Profit is earned when the sale is made. A credit sale of €36,000 counts in full in the profit figure on the day the invoice is issued, but the cash arrives 91 days later, and €9,000 of it had not arrived by 31 December. Meanwhile three cash outflows left the account and appear nowhere in the profit calculation as cash: drawings of €4,000 (a capital transaction), the €2,400 repair (which does hit profit, but as an expense, not as a timing difference), and repayments of loan capital, which are not an expense at all.
So a business can be profitable and still run out of money. Profit is an accounting measure; cash is a fact.
The scale of it. Of €36,000 of credit sales, €9,000 is sitting in customers' pockets at year end - 25% of a year's credit turnover.
3. Recommend three specific credit-control measures and estimate the cash effect of one of them.
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1. Invoice immediately and state terms in writing. Many small firms lose 30 days simply by invoicing late or vaguely. Terms of '14 days' on the invoice, printed on the job sheet, cost nothing.
2. Offer a settlement discount - with the cost calculated first. A 2% discount for payment within 10 days would cost at most 2% × €36,000 = €720 if every customer took it. To assess whether that is worth it, compare it with the alternative: continued overdraft or loan interest on €9,000 of tied-up cash. The discount also removes uncertainty, which matters more to a sole trader than the €720.
3. Chase on a schedule, not on instinct. A reminder at day 14, a phone call at day 30, a formal letter at day 45, and suspension of service at day 60 for repeat late payers. Charge interest on overdue accounts where the terms allow it.
Cash effect of a target. If debtor days fell from 91 to 45, debtors would be €36,000 × 45 ÷ 365 = €4,438. Cash released = €9,000 − €4,438 = about €4,560, which is more than double the €1,800 decline that worried her.
Also do this: credit-check new customers before extending credit at all, take a deposit from one-off customers, and stop offering credit to anyone who has been more than 60 days late twice.
Judgement: the cheapest fix is not a discount but a routine. Most late payment is not refusal, it is forgetfulness by the customer and silence from the supplier. A 30-day call costs nothing and usually recovers more than a 2% discount.