Connect with us

# Confusion Between Profit and Its Cash Flow

Published

on

Business managers don’t think like accountants (and many argue that’s a good thing). Say sales revenue to a business manager, and he thinks of collecting money from customers. Say expenses to a business manager, and she thinks of writing checks for the costs of operating the business. In short, business managers are cash flow thinkers. So, when business managers read their P&L reports, they tend to think they’re reading cash flow information. However, the sales revenue and expense information in the P&L statement has been recorded on the accrual-basis of accounting.

The sales revenue amount in your P&L statement is different than the total cash collections from customers during the year (unless you make only cash sales). And, the expense amounts in your P&L statement are different than the total amounts actually disbursed for these costs during the year. In short, when discussing profit and cash flow from profit, you’re talking about two different things — apples and oranges, as it were.

Here are two rather extreme examples that illustrate the divergence of cash flow and profit:

Suppose that a business records \$3,000,000 sales revenue and \$2,750,000 total expenses for the year. So, its profit is \$250,000 for the year.

First Scenario: Suppose that the business didn’t collect a dime of its sales revenue; it extended long-term credit terms to its customers, and none of its customers made any payments to the business by the end of the year. Assume, however, that the business paid all its expenses during the year. Therefore, cash in equals zero, and cash out equals \$2,750,000; cash flow from profit is a negative \$2,750,000 for the year despite a profit of \$250,000!

Second Scenario: Suppose that the business collected all its sales revenue for the year. However, it didn’t pay a dime of expenses; its vendors and suppliers, as well as its employees, agreed to wait for payment until next year (most unlikely, of course). Therefore, cash in equals \$3,000,000, and cash out equals zero; cash flow from profit is a positive \$3,000,000 despite profit of only \$250,000!

Of course, you don’t find such extreme examples shown above in the real world of business. But the examples bring out a valid point: Cash flow from profit depends on when sales revenue is collected and when expenses are paid. When you ask about cash flow from profit, you’re inquiring about whether cash collections from customers during the year are different than sales revenue and whether cash payments for expenses during the year are different than the expense amounts that are recorded to measure profit for the year.

A loss is bad news from the cash flow point of view. In most cases, a loss sucks money out of the business. There is no money to expand the business or to provide for cash distributions to owners (the shareholders or partners of the business who provide its owners’ equity capital). The amount of cash drain caused by a loss can be significantly higher, or significantly lower, than the bottom line amount of loss reported in the P&L for the year. It’s possible that a business could report a big loss in its P&L, and yet realize a positive cash flow from the loss. Isn’t this an odd state of affairs? How do you like them apples?

Are you looking for easy accounting tutorial? Established since 2007, Accounting-Financial-Tax.com hosts more than 1300 articles (still growing), and has helped millions accounting student, teacher, junior accountants and small business owners, worldwide.