A company can generate a profit and still experience serious cash problems.
Understanding why is fundamental to financial analysis.
Nicholas T. Rafael Jr. examines the difference between cash flow and profit because these two measures answer very different questions about financial health.
What Is Profit?
Profit represents the amount remaining after expenses are deducted from revenue.
Businesses may evaluate several forms of profitability:
- Gross profit
- Operating profit
- EBITDA
- Pre-tax income
- Net income
Profit helps determine whether the economic activity of a business is generating value.
What Is Cash Flow?
Cash flow measures actual cash entering and leaving an organization.
Cash inflows can include:
- Customer payments
- Borrowing
- Investments
- Asset sales
Cash outflows can include:
- Payroll
- Suppliers
- Rent
- Equipment
- Taxes
- Debt payments
Why Are Profit and Cash Flow Different?
Timing is one major reason.
Imagine that a company sells $500,000 of services in December but customers do not pay until February.
The business may record revenue in December while receiving the cash months later.
That delay appears through accounts receivable.
Accounts Receivable
Growing receivables can consume working capital.
A business may report strong sales while having difficulty collecting payments quickly enough to fund operations.
Finance teams therefore need to examine both revenue and collections.
Inventory
Inventory can also consume cash before revenue is generated.
Retailers and manufacturers may purchase inventory well before customers ultimately buy it.
A rapidly growing business can therefore require significant amounts of working capital.
Capital Expenditures
Equipment purchases create another difference between cash flow and accounting profit.
Cash may leave the business immediately when equipment is purchased.
However, the income statement may recognize the cost gradually through depreciation.
Debt
Borrowing money increases cash but does not create operating profit.
Likewise, repaying loan principal decreases cash but generally does not appear as a normal operating expense.
Working Capital
Nicholas Rafael considers working capital an important bridge between profitability and liquidity.
Key components include:
- Accounts receivable
- Inventory
- Accounts payable
- Accrued expenses
Changes in these balances can have a substantial effect on cash generation.
Why Finance Teams Need Both Measures
Profit answers:
Is the organization economically profitable?
Cash flow answers:
Does the organization have enough liquidity to fund its obligations?
Neither question should be ignored.
Strong financial analysis considers both.
Frequently Asked Questions
Can a profitable company run out of cash?
Yes. Collection delays, inventory purchases, capital expenditures, debt payments, and rapid growth can all create cash pressure.
Is cash flow the same as revenue?
No. Revenue reflects earned business activity, while cash flow reflects actual movement of cash.
Does borrowing increase profit?
No. Borrowing creates cash and a liability rather than operating revenue.
