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Why am I paying tax when I have no cash in the bank account?

Updated: Mar 11

A common cause of confusion for any self-employed person is understanding how they have tax to pay at the end of the financial year when they have little to no cash in their bank account. This article will highlight the differences between profit and cash and explain how your tax bill is calculated.

Profit is calculated as your business income minus your business expenses. The difference is called taxable profit, which is what you pay tax on. For example, income was $100,000 and expenses were $40,000 therefore taxable profit is $60,000. For a company, the tax on this is $16,800 (28% x $60,000).

Cash is what shows in your bank account as money flows in and out.

The key differences that create a mismatch between profit and cash are as follows:

  • Depreciation – tax-deductible expense; decreases profit but does not change cash.

  • Loan principal repayments – not tax-deductible; decreases cash but does not change profit.

  • Drawings/personal expenditure - not tax-deductible; decreases cash but does not change profit.

  • Asset purchases – not immediately tax-deductible; decreases cash immediately but the expense is claimed over several years as depreciation, so only marginally decreases profit.

  • Tax payments – decreases cash and calculated based on profit. Using the example above, after paying tax the available cash would be $43,200 not $60,000.

  • Changes in the value of livestock – if livestock are valued using National Standard Cost, each year the values change and are taxable. If livestock are valued on Herd Scheme, only the change in stock numbers is taxable. This can cause a huge difference between cash and profit.

  • Accounting entries such as rental income or FBT on private use of vehicles for companies – taxable income; increases profit but does not change cash.

  • Debtors - people who owe you money – increases profit but haven’t received the cash yet. Managing debtors is a key area to managing cashflow for commercial businesses, not so much for farmers.

  • Creditors – people you owe money to – decreases profit but haven’t paid the cash yet.

It can be helpful at the end of the financial year to do a reconciliation between profit and cash with your accountant to see where the cash is going. A common example we see is as follows:

Profit: $150,000 Drawings: $100,000 Principal repayments: 10,000 Depreciation: $10,000 Tax paid during year: $40,000 Cash in bank: $10,000

In this example, the financial statements show a profit of $150,000 but they only have $10,000 in their bank account. This is because they have taken drawings of $100,000 and paid tax of $40,000, which if we deduct these from the $150,000 profit this leaves $10,000 (depreciation and principal repayments cancel each other out as they are the same amount).

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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