Why Profits Don't Equal Cash Flow (2024)

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Why Profits Don't Equal Cash Flow (6)

When small business owners get their monthly financial statements, their eyes quickly focus on the bottom line of the income statement.

Key Takeaways

  • The Blame Game: The positive profits and not-so-positive cash flow riddle is essentially an accounting issue. The situation can usually be blamed on using cash for things that don’t show up on the income statement.

  • The Reasons for Changes in Cash Flow: Knowing when and how expenses and revenues are recognized on the income statement is key evidence in the negative cash flow mystery.

  • See The Full Picture With A Statement of Cash Flows: To see an accurate picture of your cash flow, you have to consider more than your company’s cash disbursem*nts. To understand the disappearing cash magic trick, take a closer look.

If profit is good, their gaze gradually moves to cash in the bank or the cash account on the balance sheet, where they may be surprised to see that cash didn’t grow as much as they thought it should.

The owner then asks the question, “How can I have made a profit but have so little cash?”

To understand where your cash has gone, you must first understand the relationship between profit and cash flow, and how each is calculated.

Why Profits Don't Equal Cash Flow (7)

Profit vs. Cash Flow: Is Cash Flow the Same as Profit?

In the non-business world, cash flow and profit might sometimes be thought of as the same thing. If you have money flowing into your personal bank account, you might think of this as a personal profit.

In business, however, cash flow and profit are two very different figures that come from different financial reports. So, what does profit mean in business and what does cash flow mean in business?

Profit Definition in Business

Profit = Total Revenue - Total Expenses

Profit (also referred to as net income) is shown on an income statement and equals revenues minus the expenses associated with earning that income. This measures the ongoing sustainability of the company.

Profit is also one of the figures used to calculate cash flow. In fact, you’ll find net income on a cash flow statement’s top line.

Cash Flow Definition in Business

Cash flow (also called net cash flow) measures the ability of the company to pay its bills. It is calculated using a cash flow statement that records all of the money flowing into and out of the business over a set period of time.

The cash balance is the cash received minus the cash paid out during the time period. When cash on hand is negative, the company has spent more cash than it has brought in during that time period. Conversely, if the cash on hand is positive, the company has brought in more money than it has spent during the time period.

There are a few different formulas for calculating and thinking about cash flow in different ways (free cash flow is the one that you’ll use to assess your business’s overall cash flow for a set period of time):

  • Free Cash Flow = Net Income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure
  • Operating Cash Flow = Operating Income + Depreciation - Taxes + Change in Working Capital
  • Cash Flow Forecast = Beginning Cash + Projected Inflows - Projected Outflows = Ending Cash

Cash Flow vs. Profit: What’s the Difference?

Let’s look at an example for further clarification.

  • Profit for the Period = Revenue ($10,000 total sales) less expenses ($5,000) = positive $5,000 profit
  • Cash flow for the period = Cash-in ($5,000 cash sales) less cash-out ($5,000 cash paid out) = $0 cash flow

In this scenario comparing net income vs. cash flow, the business had $5,000 in net income but a net cash flow of $0. How can this be?

The Ultimate Cash Flow Guide

Why Profits Don't Equal Cash Flow (8)

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Net Income and Cash Flow Variances: The Blame Game

The positive profits and not-so-positive cash flow riddle is essentially an issue with accounting that commonly occurs in two types of situations:

Unreflected Cash Items

Firstly, variances can often be blamed on using cash for items that do not appear on the income statement.

Accrual-Basis Accounting

Secondly, cash flow and profit variances can also occur as a result of the accrual accounting method. The timing difference between when revenues and expenses are recognized in the books compared to their actual collection and payment can result in variances where the books recognize revenue or expenses that have not yet actually been received or paid.

Since accountants generally prepare financial statements using accrual-basis accounting, this is a common reason for variances between cash flow and profit. With this method, expenses are reported only when goods or services are completely consumed, regardless of when the bill got paid.

Similarly, revenues are reported only when the product or service has been delivered to the customer and the company has earned the right to receive a cash payment, regardless of when the client pays you.

Side note: Cash-basis accounting, which tracks the movement of cash through a business to calculate net income, would show a more accurate reflection of a business’s cash in the bank.

However, this method is not the best practice because it shows profitability based on cash flow and does not show the true profit of the month. Standard accounting best practices follow the matching principle in which expenses are matched with their associated revenues in a reporting period.

Read More: Seasonal Business Or Not, Cash Flow Can Get Muddy Fast

The Reasons for Changes in Cash Flow

Knowing when and how expenses and revenues are recognized on the income statement is key evidence in the negative cash flow mystery. To see the full cash flow story, you want to look at the Statement of Changes in Cash Flow.

The cash account in the cash flow statement has three areas to investigate:

  • Cash Flows From Operations
  • Cash Flows From Investments
  • Cash Flows From Financing

To help you in your detective work, here are some examples of situations that could be the source of a company’s negative cash flow and positive profit discrepancy.

Read more: How to Improve Your Cash Flow During Inflationary Times

#1 Investing in Consumables

Your company has spent more in cash than what is expensed by accounting because the business is investing in consumable products (Cash Flows From Operations).

Let’s say a vendor had a sale on an inventory item. You take advantage of the sale and buy $1,000 of the item, but only sell $500 worth of the item during the reporting period.

In this case, your cash account would be reported on the balance sheet as a negative ($500 cash in, minus $1,000 cash out = -$500) but wouldn’t show up on the income statement because it's not a cost until you sell that product.

#2 Offering Customers Credit

Your business allows its clients to pay for its goods or services via a credit account (Cash Flows From Financing).

When a customer pays with credit, the income statement reflects revenue but no cash is being added to the bank account. Similarly, any cash down payment will be reflected in the cash account, and the balance of the customer’s purchase will appear in accounts receivable on the balance sheet.

Meanwhile, the entire sale is recognized as revenue on the income statement, reflecting the legal obligation by the customer to pay for the purchase they made on credit. Therefore, in this scenario, the business could show a hefty profit, but without any cash having been exchanged between the two parties.

Read More: How a Credit Policy Can Stop Cash Flow Problems Before They Start

#3 Making Investments

Your company is buying equipment, products, and other long-term assets with cash (Cash Flows From Investments).

As a growing small business, you are likely to be spending more than you have in profits because the company is investing in long-term assets to fuel its expansion. These purchases typically involve an expenditure of cash.

However, the expense won’t be recognized in the same period as the cash outlay. That’s because the accounting standard is to expense the long-term asset gradually through depreciation over the useful life of the assets.

#4 Repaying a Loan

Your company decides to repay a loan from the bank (Cash Flows From Financing).

When a loan comes due, your business needs to use its cash to repay the bank. That can decrease your cash account substantially. However, accounting guidelines only allow the interest from the loan to be deducted as an expense to deduct when calculating profits.

Therefore, the principal payment lowers the cash account but does not affect profits.

#5 Prepaying an Expense

You purchase insurance or pre-pay rent (Cash Flows From Operations).

When your business makes a payment in advance, more cash is paid out than the product consumed during the period. Examples of typical prepaid items are taxes, insurance, and rent.

With accrual accounting, only the portion of the prepaid expense incurred during the reporting period will be deducted from revenues. Therefore, cash flow may suffer from the prepayment, but the expenses won’t take the same brunt. That scenario enables your business to filter more income to the bottom line for positive profits.

See the Full Picture With a Statement of Cash Flows

To see an accurate picture of your cash flow, you have to consider more than your company’s cash disbursem*nts. To understand the disappearing cash magic trick, take a closer look at the statement of cash flows and the changes in the balance sheet.

You’ll find your cash in hidden asset accounts like inventory, fixed assets, accounts receivable, and prepaid insurance. On the other hand, you might find hidden cash in using cash to pay down debt, such as credit cards, accounts payable, or bank loans.

That observation may help you realize that you may need to hold off on more investments and cash outlays – at least until your cash flow is king once again.

Why Profits Don't Equal Cash Flow (9)

Quickbooks cash flow forecast

Why Profits Don't Equal Cash Flow (2024)


Why Profits Don't Equal Cash Flow? ›

As a growing small business, you are likely to be spending more than you have in profits because the company is investing in long-term assets to fuel its expansion. These purchases typically involve an expenditure of cash. However, the expense won't be recognized in the same period as the cash outlay.

Why profits don t equal cash flow? ›

Indication: Cash flow shows how much money moves in and out of your business, while profit illustrates how much money is left over after you've paid all your expenses. Statement: Cash flow is reported on the cash flow statement, and profits can be found in the income statement.

Why are accounting profits and cash flows generally not the same? ›

Answer and Explanation:

The correct answer is C- different because of GAAP rules regarding the recognition of income- accounting profits and cash flows are not the same because GAAP allows for recognition of revenue separate from the cash flows receipt.

Why does not cashflow equal net income in most scenarios? ›

Non-cash expenses, such as depreciation, amortization, and share-based compensation, must be included in net income, but those costs do not reduce the amount of cash a company generates in a given period. As a result, these expenses are added back into the cash flow statement.

Why is accounting income not the same as cash flow give two reasons? ›

The main difference between accounting income and cash flow is that accounting income is a measure of profitability, while cash flow is a measure of liquidity. Accounting income includes non-cash items such as depreciation, which reduces taxable income but does not affect cash flow.

Why is profit more important than cash flow? ›

Alternately, a business may see increased revenue and cash flow, but there is a substantial amount of debt, so the business does not make a profit. The absence of a profit eventually has a declining effect on the cash flow. In this instance, profit is more important.

What is the cash profit equal to? ›

Cash profit is a measure of a company's financial health, calculated as the cash inflows from operating activities minus the cash outflows from operating activities. This measure is also known as the operating cash flow.

How do you convert profits to cash flows? ›

To convert your accrual net profit to cash, you must subtract an increase in accounts receivable. The increase represents income that has been recorded but not yet collected in cash. A decrease in accounts receivable has the opposite effect — the decrease represents cash collected, but not included in income.

Why a company with very high net profits can still be in cash flow problems? ›

Answer and Explanation: When a company uses accrual accounting, the net profit of the company and net cash flow differs. In accrual accounting, transactions are recorded when revenue is generated or expenses are incurred not when necessarily cash is received or paid.

Can a company have profits but no cash? ›

In other words, a company can appear profitable “on paper” but not have enough actual cash to replenish its inventory or pay its immediate operating expenses such as lease and utilities. If a company cannot purchase new inventory, it will slowly become unable to generate new sales.

How can you be cash flow positive but not profitable? ›

Expenses are recorded at the time they are incurred, not when they are paid. For example, a company might record a substantial expense in Q4 but not have a cash outlay until the next year when the invoice is paid. As a result, the company might post a net loss in Q4 while maintaining a positive cash position.

How can a company be profitable but have negative cash flow? ›

A business could make net profit while having negative cash flow. Earning revenue does not necessarily mean that the company has received cash immediately. The actual movement of cash may happen later. For instance, a company sold goods and accrued profit on the income statement but did not receive the money yet.

What are the two 2 factors that affect your cash flow? ›

6 Crucial Factors that Affect Your Cash Flow
  • Receivables Management. Accounts receivable is the balance of money owed to a company after rendering products and services. ...
  • Investing and Financing. ...
  • Employee Management. ...
  • Market Environment. ...
  • Payment Management. ...
  • Working Capital Acquisition.
Aug 16, 2019

What are the three major components of a cash flow statement? ›

The three main components of a cash flow statement are cash flow from operations, cash flow from investing, and cash flow from financing. The two different accounting methods, accrual accounting and cash accounting, determine how a cash flow statement is presented.

Can a company have negative cash flow but a positive profit Why? ›

Yes, a profitable company can have negative cash flow. Negative cash flow is not necessarily a bad thing, as long as it's not chronic or long-term. A single quarter of negative cash flow may mean an unusual expense or a delay in receipts for that period. Or, it could mean an investment in the company's future growth.

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