In: Accounting
It is relatively easy “to manufacture profit, but virtually impossible to create cash” explain?
Answers
When small business owners get their monthly financial statements, their eyes quickly focus on the bottom line of the income statement.
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?”
The situation where profit and cash flow are at odds is very common for a small business which must invest in assets in order to grow. The reasons can always be seen on the balance sheet.
To understand where your cash has gone, you must first understand the relationship between profit and cash flow, and how each is calculated.
Profit vs. Cash Flow
Profit
Profit 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.
Cash Flow
Cash flow measures the ability of the company to pay its bills. 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.
What’s the difference?
Let’s look at an example for further clarification.
The Reasons for Changes in Cash Flow
Knowing when and how expenses and revenues are recognized on the
income statement are key evidence in the negative cash flow
mystery. But for the true 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:
To help you in your detective work, here some examples of situations which could be the source of your company’s negative cash-flow, positive profit discrepancy.
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).
2. Offering Customers Credit
Your business allows its clients to pay for its goods or services via a credit account (Cash Flows from Financing).
3. Making Investments
Your company is buying equipment, products and other long-term assets with cash (Cash Flows from Investments).
4. Repaying a Loan
Your company decides to repay a loan from the bank (Cash Flows from Financing).
5. Prepaying an Expense
You purchase insurance or pre-pay rent (Cash Flows from Operations).
To see an accurate picture of your cash flow, you have to
consider more than your company’s cash disbursements. 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. Or 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.