Profit and Cash Flow: What's the Difference?
We often hear from business owners who report a healthy profit at year end, but scramble to pay their bills on time throughout the year. This scenario is especially common for start-ups and companies that work on long-term projects. These types of businesses tend to have a long cash conversion cycle that causes a significant disconnect between cash in the bank and the profit reported on income statements and tax returns. Here’s why.
An abstract concept
No matter how you measure profit — as taxable income, net income, or earnings before interest, taxes, depreciation and amortization (EBITDA) — it’s an abstract accounting concept. In a nutshell, profit is the difference between revenues and expenses for the period. It may include noncash charges, such as depreciation and amortization. It also may be skewed by the matching principle, which ties expenses to the period in which the corresponding revenues were earned (regardless of when the expenses were actually paid).
In accrual accounting, revenue refers only to the money you have earned, not what you have actually collected in cash. Expenses refer only to the costs you have incurred, not what you have actually paid in cash.
A more meaningful gauge
Profits reported on income statements and tax returns also omit other expenditures that eat away at cash, including dividends, equipment purchases and principal payments on loans. On the flip side, profits don’t reflect infusions of cash from new loans or capital contributions from investors. Moreover, sales of unused equipment are only partially reported in profits to the extent that there’s a gain or loss on the sale.
For a more meaningful metric of whether your business is generating (or draining) cash, check out the statement of cash flows. This lesser-known financial statement is divided up into three sections: operating, investing and financing cash flows. Each section shows the sources and uses of cash.
Operating cash flow represents the money your company actually collects or pays out in its operations. Operating profit records sales as they are made and expenses as they are incurred, irrespective of when the cash is received or paid.
For example, you ship $1,000 worth of goods to a customer and book $1,000 in revenue, but until the customer pays there is no effect on cash flow. Expenses affect cash flow not when they are officially recorded, but rather when you make a cash payment, which could be at the same time they are incurred, or before or after. Non-cash expenses such as depreciation do not affect operating cash flow at all, but depreciation does reduce net income.
Cash is king
Need help understanding your statement of cash flows? Contact us. It’s the first step toward more efficient working capital management.
Anne Taros, CPA
Anne Taros assists a variety of clients with business and tax-related issues domestically and abroad. She works with small and mid-sized clients in the manufacturing, service, retail and wholesale industries, offering business advisory services, general ledger management, and tax planning and compliance. Contact Anne at firstname.lastname@example.org or (248) 244-3160.