Why cash and profit are different

As managers and business leaders we tend to focus our efforts on the income statement.  After all isn’t business all about being profitable?  The income statement measures profit so that should be our focus as we look at the success of our business.  If the bottom line of the income statement is positive then life is good.  If it is negative, then it’s time to find some outside investors.

Well what many managers and owners don’t understand is that the real key to being successful in business is having cash flow.  Cash is king.  A business fails when the cash runs out not when the company had losses on the income statement.  Cash flow is becoming a key measure on Wall Street right now.  Why?  Because investors and analysts know that in a liquidity crunch if a company can generate its own cash it will survive.  A second reason is that cash flow is not subject to as many estimates and assumptions as profit from the income statement.

So now the question how can cash and profit be that much different?  There are really three reasons why cash flow and profit do not match up well.

First, we book or record sales not when we collect on them but when the product or service is delivered.  This can lead to sales on the income statement that will not be collected for a great deal of time.  In most cases it can take 30-90 days to collect on those sales recorded this month on the income statement.  In the case of long-term contracts the recognition of the sale and the collection of the cash can be more than a year a part.

Second, we record expenses on the income statement when those expenses are incurred not paid in cash.  This is part of the accrual process.  The income statement is about matching expenses with sales.  So if I make payroll on September 1st, I do not charge that expense to September.  Rather, I charge it to August since the September 1st payroll is to cover work that was performed in August.  So we show an expense in August even though the cash did not go out until September.

Third, when I spend my cash to buy capital equipment for a business, things like computers, building, and vehicles, I depreciate them on the income statement as expenses over several years.  When I spend my cash on capital it’s gone.  On the other hand, the expense associated with this capital takes years to impact the income statement.

When one takes these three issues into account, it’s easy to see why cash and profit are two different things.  The message here for the financially intelligent business manger is to watch both cash and profit because understanding them is critical.  Why do most businesses fail?  Because they run out of cash.