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Business owners often confuse Profit with Cash and believe that whatever they have earned should be available in cash. However, this is not the case in many situations, and we will explain below why Profit is not equal to cash.
First, let’s understand what cash flow and profit and loss account mean:
Cash flows represent the amount of money flowing in and out of your business. There are three sources of cash:
Cash flow from operating activities: the amount of money you bring in from your core business activities
Cash flow from investing activities: the purchase and sale of investments, property, plant, and equipment.
Cash flow financing activities: the net change in cash related to raising capital, shares, dividend distributions, and loan repayments.
Profits or loss is the amount that appears at the bottom of your profit and loss report (i.e. your revenue less expenditure).
There can be several reasons why profits are not necessarily equal to cash. Some of the factors that cause this difference are explained below:
Accrual basis of accounting
The accounting principles require the revenues and expenses to be recorded when they occur, even if the cash has not been received or paid; this is called the accrual basis of accounting. The accrual basis is used to record transactions in the period they occurred.
Example: You sold a laptop to your customer on credit on July 15 at a net profit of $100. The payment terms were 30 days credit, i.e., payment to be received by August 15. The revenue is recorded in July when the sale took place. You see a net profit of $100 from that transaction in July but the cash won’t be shown in your book until August when the customer made a payment.
Capital Expenditure
To run your business, you also need to incur capital expenditure.
‘A capital expenditure (Capex) is a company's investment to acquire or upgrade fixed, physical, non-consumable assets, such as a building, computer or new business.’
This Capex is not an expense in the profit and loss account; its depreciation (i.e., the cost for the wear and tear of an asset) is included in the profit and loss account.
Example: On July 1, 2022, ABC Company purchased a Manufacturing Plant for $1 million. This amount will be recorded in ABC's balance sheet at the time of purchase. If the expected useful life of the plant is 40 years and ABC chooses the straight-line depreciation method, each year ABC will recognize $25,000 ($1 million divided by 40 years) as depreciation expenses. You can see from this example that even though ABC spent $1 million in FY22-23 on purchasing this plant, only $25,000 is reflected in the income statement.
Prepayments
Certain payments are made in advance or as prepayments. E.g., you rent an office and pay quarterly rent in advance. So, one month’s rent will be charged to expenses in the profit and loss account, whereas two months’ rent will be parked on the balance sheet as prepayment.
Inventory
To carry on the business, you need to purchase specific items that are part of your inventory. Not all purchases in a particular period (a month or a year) are sold to customers in the same period. Unsold goods remain as inventory and are part of the balance sheet, not the profit and loss account, even though cash has been consumed in purchasing such goods.
Loans / Investments
If you obtain a loan from the bank, the money you receive is not an income but a liability that you have to repay in the future.
Similarly, you invest your money in another company which results in a cash outflow from the Company. This transaction does not have the corresponding profit and loss impact.
Conclusion
In short, higher profits do not always mean higher cash. The difference is that many accounting and business transactions impact one item but not both. One approach to reconciling the profits with cash can be to make profit and loss accounts using a cash basis of accounting. While the cash method is easy to use, it does not show a clear and accurate picture of your long-term finances. Thus business owners need to be careful in treating profits as cash; instead, they should prepare a separate cash flow statement to better understand their cash movement.
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