The income statement of a company should show its revenues and cost of sales without VAT, so do we need to include it in our model at all? Following our simplicity rule (see our white papers section for more info), if something doesn’t have a material impact, there’s a good argument for leaving it out. Let’s consider how VAT works and whether it matters to a forecast. The specifics below are relating to basic UK VAT. There are many quirks which we can’t cover here, so this is just a basic illustration:

Most businesses act as unpaid tax collectors for the government when it comes to VAT. If I’m a VAT registered company and I sell a widget for £250k, I have to add 20% (currently for most businesses in the UK) to the amount I charge my customer and bill them £300k. If I bought some components to make the widget with a total cost of £100k, my VAT registered supplier will have added £20k VAT and sent me a bill for £120k. To help follow all the movements, take a look at the diagram below.

My accounts show £250k sales and £100k cost of sales (ie without VAT); a profit of £150k, so I put my feet up for three months and take a well-earned break. At the end of three months, I submit my VAT return for the quarter which shows I have charged ‘output VAT’ of £50k and paid ‘input VAT’ of £20k. The difference is the net amount of VAT I have collected on behalf of HMRC (£30k) and they rather like me to send it to them around the 15th of the next month.

Between the time of the sale of the widget and the payment to HMRC, the £30k should sit in a VAT creditor (payable) account. This goes back to zero when I pay my VAT bill.

There’s a bit more to it than that – I’m in the happy position of having my customer pay me 30 days from invoice, but paying my supplier after 60 days. Just after selling the widget, I will have a debtor (accounts receivable) of £300k and a creditor (accounts payable) of £120k – that is, the amounts including VAT. When I receive the cash from my customer my cash balance increases by £300k, and 60 days after my supplier invoiced me for the components I pay out the £120k. The net increase to my cash balance therefore has been £180k and the both the debtor and creditor are reduced to zero. From the £180k I pay the £30k net VAT as calculated above, leaving me £150k, which is the profit on my widget.

Wow – a fair bit of accounting has to go on there, so if you really don’t need to track the cash movement, perhaps you can ignore VAT ?

Wait a minute – some goods are VAT exempt or zero rated, or at a reduced rate. The important distinction is that if you sell VAT exempt goods, you can’t reclaim the VAT on related purchases, so you bear the cost of the VAT. It then becomes much more important to include VAT in your model, as it affects not only cash timing, but the profit and the amount of cash you pay as well. Details of VAT rules can be found at .

Project finance is worth a special mention here, as companies set up to construct and operate an asset over a long term (often called Special Purpose Vehicles or SPVs) will spend large amounts of money during construction, on which VAT will be charged, creating a working capital requirement until the VAT can be reclaimed. In many such project companies, a VAT facility will be agreed with a lender to fund the short-term cash requirement for the VAT bill. Other than that, the VAT is often ignored for such companies, as the cash impact is not material to the overall project returns.

We’ve only scratched the surface here, there are many other factors involved with VAT depending a company’s particular circumstances. Things like payments on account, returns and bad debts also need to be correctly treated if VAT is included. These can have significant impact on cash, so if that is a focus of your model, you probably need to model VAT properly. Call us if you need help in building a model to deal with your VAT or any other financial modelling issues.

Call 0845 869 4960 to find out more about modelling VAT