Profit compared with cash flow

In simple terms

Profit and cash measure different things.

• Profit answers: did this business earn more than it cost to run, during this period? Accountants record a sale when it is made and a cost when it is incurred, whether or not money has changed hands yet. This is called accrual accounting, and it is how companies report their profits.
• Cash flow answers: how much money actually came into the bank account, and how much went out?

Over many years the two tend to come together, because sales are eventually paid for and costs are eventually settled. But in any one period they can be far apart, and a business can be profitable on paper while running out of money in practice.

What causes the gap

Selling on credit. When customers are given time to pay, the sale counts as revenue now, but the cash arrives later. The money owed by customers is called receivables.

Building up stock. Cash spent on stock that has not yet been sold leaves the bank account, but it only becomes an expense when the goods are sold.

Buying equipment. A ₹50 lakh machine is paid for now, but its cost is spread over its useful life as depreciation, say ₹5 lakh a year for ten years. In the year of purchase, cash falls by ₹50 lakh while profit falls by only ₹5 lakh.

Paying suppliers late, or early. Buying on credit from suppliers keeps cash in the business for longer; paying them quickly does the opposite.

Borrowing and repaying loans. Taking a loan brings in cash that is not revenue; repaying the principal uses cash that is not an expense. Only the interest counts as an expense.

A profitable business that runs out of cash

Why it matters

Investors care about cash because cash is what pays salaries, suppliers, lenders and, in the end, dividends. A company that reports rising profits while its cash keeps draining away may be:

• growing quickly and tying up money in receivables and stock, which needs financing;
• struggling to collect from customers;
• recognising revenue too aggressively; or, in the worst cases,
• reporting profits that are not real.

The cash flow statement, covered in the next module, shows the actual cash coming in and going out. Comparing its cash flow from operations with net profit over several years is one of the most useful checks an investor can make.

Limitations

A gap between profit and cash is not automatically a bad sign. A growing, healthy business often has lower cash flow than profit because it is investing in stock and extending credit to new customers. A business that has just bought a large factory will show a big cash outflow for good reasons. The question is always why the gap exists and whether it is closing over time.

Cash can also be flattered, for example by delaying payments to suppliers. No single number tells the whole story.

Common mistakes

• Assuming profit means cash in the bank. The two can be very different in any given year.
• Treating rising receivables as harmless. If customers are taking longer and longer to pay, cash may never arrive.
• Counting a loan as income. Borrowed money increases cash but is not revenue or profit.
• Forgetting depreciation. Equipment bought in the past uses no cash this year but still reduces profit.

Try it yourself

A made-up company reports for the year: net profit ₹40 crore. During the year, receivables rose by ₹30 crore, stock rose by ₹15 crore, and it bought new equipment for ₹25 crore. Depreciation was ₹10 crore.

1. Ignoring everything else, did cash rise or fall during the year, and roughly by how much?
2. Which of these items reduced cash without reducing profit?

Answers: start from profit ₹40 crore, add back ₹10 crore of depreciation (no cash spent), subtract ₹30 crore of uncollected sales, ₹15 crore of extra stock and ₹25 crore of equipment: ₹40 + ₹10 − ₹30 − ₹15 − ₹25 = −₹20 crore. Cash fell by about ₹20 crore despite a ₹40 crore profit. The receivables, stock and equipment purchases reduced cash without reducing profit.