From the financial point of view, you’re in business to make a profit. This is obvious, isn’t it? Or are you in business to make money? You see, the two are not the same. Even though the two expressions making money and making profit are used interchangeably, they should not be. Profit is an accounting measure. The bottom-line profit number you see in a profit report hardly ever exactly equals the increase in your cash balance from your profit-making activities during the period. In fact, profit and cash flow can be far apart, especially so for the start-up year of a business—and for any business, on occasion. Hardly ever are profit and cash flow from profit exactly the same for the year. Profit and cash flow are identical only if a business uses the cash basis of accounting to record its revenue and expenses.
The same issue I ever discussed with fellow accountants in the Facebook. The fast majority say profit is the most important of the financial number. Yes that is correct from the financial’s view as it is mentioned in preface. This post emphasizes the issue of differentiating profit with cash. Enjoy!
Cash-Basis Accounting and Its Flaws
Many small businesses do not sell products; they sell services. Scan the Yellow Pages if you want to see the broad variety of service businesses. A service business does not carry an inventory of products for sale that has to be accounted for, which is a major determinant of the accounting system a business should use.
Cash-basis accounting basically is checkbook bookkeeping. You record actual cash collections from sales to customers as revenue, and you record actual cash payments for the expenses of the business. Cash inflow from revenue minus cash outflow for expenses equals the profit (or loss) for the year. Of course, cash outflows for expenses should include only costs of operating the business, and all cash inflow from sales should be recorded.
As an accountant, I can say in bold that cash-basis accounting is not a good method for measuring the actual, or true, profit for any business—whether it is small or large or sells services or products. As a matter of fact, the income tax law puts restrictions on using cash-basis accounting.
Most businesses actually use a modified cash basis of accounting; the amounts of cash outlays for certain types of asset purchases must be allocated to expense over several years.
The problems with cash-basis accounting start with recording sales revenue. In many cases, a business has billed customers for services provided to them but has not yet received the customer’s payments by the end of the year. Using cash-basis accounting, the amount of earned but uncollected revenue is not recorded as revenue in the year. The revenue account includes only actual cash collections from customers. Put another way, the business has an asset, called “accounts receivable” that is not recorded on the books by cash-basis accounting.
For those service businesses that sell only for cash, checks, or credit cards, this is not a problem. But many service businesses extend credit to their customers, and their year-end uncollected receivables can be sizable. Cash-basis accounting has serious flaws on the expense side of the ledger as well. When you cut a check, you immediately record the entire amount paid as an expense, with no thought regarding the periods benefited by the outlay.
Furthermore, you don’t record an expense until you cut a check when using cash-basis accounting, there’s no thought of putting expenses in their correct periods, or the periods benefited by the outlays. Expenses are simply recorded when they are paid, and that’s that. The result is that some expenses are over-recorded and some expenses are under-recorded in the year they are paid. Therefore, you don’t have a true measure of your profit for the year.
The income tax law recognizes the wrong timing of expenses by cash-basis accounting. The amounts paid for assets that benefit more than one year cannot be deducted entirely in the year of payment. The costs of these assets must be allocated over more than one year.
Assume that you buy a computer for your business, or a delivery truck, or office furniture and equipment, or whatever. Such assets provide usefulness for several years. Do you really want to expense the entire cost in the year of purchase?
The year of purchase would take a big hit, and the other years would escape any charge for using the assets. Doesn’t it make more sense to spread the cost of these assets over the several years of their use? Accountants call this “depreciation”; each year is allocated a share of the cost of the asset.
Equally troubling, cash-basis accounting fails to record the liabilities of a business at the end of the year for unpaid expenses. For instance: a business may have utility and telephone charges that have not been paid. Or, at the end of the year, a business may owe commissions for sales made during the latter part of the year. Assume it has collected on these sales. So, the sales revenue has been recorded. Because the commissions haven’t been paid, the expense hasn’t been recorded. There’s an obvious mismatch of revenue and expense here. Many businesses have sizable amounts of unpaid expenses at the end of the year. Cash-basis accounting does not record the liabilities for these unpaid expenses.
Accrual-Basis Accounting [Its Good and the Bad]
Cash-basis accounting, as just discussed, has serious shortcomings. Most businesses need a more complete and better accounting system for measuring their annual profit and for recording their assets and liabilities. This more comprehensive recordkeeping system is called accrual-basis accounting. Basically, the accrual basis goes beyond only recording cash inflows and cash outflows. Accrual-basis accounting records the economic reality of a business.
Sales are recorded when the revenue is earned, regardless of when cash is collected from customers. Expenses are recorded against sales revenue or in the period benefited, regardless of when cash is paid for these costs. The costs of long-lived assets are spread over the several years of their use. And, the costs of products are held in an inventory asset account and are not released to expense until the products are sold to customers. Thereby, the cost of products sold is matched with the revenue from the sale of the products. These are the essential features of accrual-basis accounting.
The “good” of accrual-basis accounting is twofold:
- You get a much truer and more accurate measure of profit for the year; and
- The assets and liabilities of the business are recorded, so the financial condition of the business can be determined.
When issuing financial statements to outside parties (banks, non-management owners, credit rating agencies, and so on), a business is duty bound to use accrual-basis accounting. If it does not use accrual-basis accounting, a business should clearly include a warning in its financial report that cash-basis accounting (or some other basis of accounting) is used to prepare its financial report.
Accrual-basis accounting is necessary for preparing a correct profit report for the year and for preparing a correct statement of financial condition at the end of the year. These are overpowering reasons for using accrual-basis accounting.
However, the accrual basis comes with a price. Accrual-basis accounting is much more complicated than cash-basis accounting, to say the least. Accrual-basis accounting methods are more technical and not as intuitive as those of the much simpler cash-basis accounting.
Another disadvantage of the accrual basis is that, well, it’s not the cash basis. In particular, accrual-basis revenue and expenses amounts for the year are not the cash inflows and outflows for the year. Because of differences between accrual-basis amounts and cash flows, the bottom-line profit for the year (on the accrual basis) does not reveal cash flow for the year. This is a major inconvenience of accrual basis accounting.
Suppose your business earned $120,000 profit for the year, which we read in your profit-and-loss (P&L) report for the year. We don’t have a clue concerning your cash flow from profit for the year. From the profit report itself, you can’t tell a thing about cash flow. You could stare at it a long time, but it wouldn’t do any good. For instance, sales revenue for the year tells you nothing about the amount of cash collected from customers during the year. You could hazard a guess that the two amounts are not far apart, but you don’t really know.
A profit report summarizes revenue and expenses for the year, leading down to bottom-line profit for the year. Now here’s a neat idea:
Why not prepare a cash flow report to go along with a profit report?
It would not replace the profit report, nor in any way offer a second measure of profit. No, the cash flow report would simply present a cash flow look at the profit activities for the period.
In fact, accountants do prepare a cash flow report. It summarizes cash inflows and outflows for revenue and expenses of the year, leading down to the bottom-line increase or decrease in cash for the year.
Next, let’s go further in more detail where we can draw a better perspective in this issue. Read on…
Business Start-Up Year Scenario
Let’s use a scenario, in which the business earns a profit for its first year (no small accomplishment, to be sure). In below table, the cost of goods (products) sold expense is separated from the other variable expenses of the business.
Sales Revenue $1,200,000
Cost of Goods Sold (600,000)
Gross Margin $ 600,000
Variable Operating Expenses (120,000)
Margin $ 480,000
Fixed Operating Expenses (360,000)
Profit $ 120,000
The cost of products (goods) sold is generally the largest variable expense of businesses that sell products. Accordingly, it is the first expense deducted from sales revenue both in external income statements and in internal P&L reports to managers. Bottom-line profit depends first of all on earning enough gross margin: Gross margin equals the sales price of a product minus its cost (We should warn you that determining the cost of a product is not as straightforward as you might think).
The spread between sales price and product cost is also called the markup. Suppose, for example, you sell a product for $100 and its cost is $60; its markup is $40. The markup is two-thirds, or 67%, of cost:
$40 markup / $60 cost = 67%
Alternatively, the markup can be calculated as 40% on the $100 sales price. Be careful which base is used to compute the markup percent.
Showing cost of goods sold as a separate first-line expense helps in understanding one major reason why cash flow differs from profit. Cost of goods sold expense for the year is not, we repeat, is not a cash outflow amount for the year. The cost of goods sold expense for the year is the total amount removed or taken out of the business’s inventory asset account in order to record the cost of products sold and delivered to customers.
Cash outflow depends not on the cost of products sold during the year but rather on the cost of products purchased or manufactured during the year and on when the business pays for these acquisitions. In many cases, a business buys or manufactures considerably more products than it sells during the year. In other words, it increases its inventory. An increase in inventory, to the extent that the inventory accumulation has been paid for, means that cash outflow is larger than the cost of goods sold for the year.
A knee-jerk reaction is to presume that the sales revenue and expense numbers in a P&L report equal the cash flow amounts for the period. But this can’t be true; it would mean that a business is using cash-basis accounting instead of accrual-basis accounting.
Almost all businesses of any size must use accrual-basis accounting to measure profit performance and to record financial condition. Business managers cannot find cash flows in their P&L reports. They must look to another financial report to learn the cash flows generated by sales and expenses for the period.
The Nonprofit Cash Flows
Let me ask you a simple question; what does “cash flow” means?. Well, the term could be used in a very broad or global sense, or it could be used in a more narrow sense, such as cash flow from making profit. In the broad sense, cash flow refers to all sources of cash inflows and all uses of cash outflows.
Assume in our example that early in the start-up year, your business borrowed $300,000, which has to be repaid in the future and on which interest is paid, of course. And assume that you and the other owners invested $300,000 money in the business at the beginning of the year. You understand that the $600,000 cash inflow from debt and equity (ownership) sources is not included in the company’s $1,200,000 sales revenue for the start-up year. The $600,000 increases your cash balance. But this is not cash flow from profit-making operations during the year. In summary, your business received $600,000 cash from sources of capital. And your business also received money during the year from customers for sales to them.
Assume, further, that during the start-up year, your business paid a total of $500,000 for the purchase of various long-lived operating assets that will be used for several years. This list includes a building, forklift trucks, shelving, office furniture, computers, delivery trucks, and so on. The $500,000 capital expenditures, as these investments are called, are recorded in asset accounts when purchased. The cost of each asset is spread out, or depreciated over, the predicted useful life of the asset. Suppose that $50,000 of the assets’ total cost is recorded as depreciation expense in your first year. The $50,000 depreciation expense is included in fixed operating expenses.
Keep this in mind; it’s important for understanding cash flow from profit.
The next table summarizes the nonprofit cash flows of your business for its first year. Cash inflows from debt and equity capital sources were $100,000 more than cash outflows for capital expenditures.
Borrowings on Interest-Bearing-
Capital Invested in the Business-
by Owners 300,000
Investments by Business in-
Long-Term Operating Assets (500,000)
Net Cash Flow $100,000
So, you have $100,000 in the bank at the end of the year—before taking into account the increase or the decrease in cash from your profit-making activities during the year. The previous (first) table reports that you earned $120,000 profit for the year. However, as harped on earlier, this is not the amount of cash flow from profit.
Now, assume that the business’s cash balance at the end of your first year is $90,000. Therefore, your profit-making operations during the year must have had the effect of decreasing your cash balance.
In other words, cash flow from profit was negative for your start-up year. On the one hand, you did very well by earning a profit in your start-up year, and not a bad profit at that. On the other hand, your business suffered a $10,000 decrease to its cash balance, which is not too bad for a start-up year. You’re probably wondering why you did so well in making profit but so poor in making money.
A word of warning here: The cash flow from profit during the start-up year of a business usually is negative. But, in many cases, the entrepreneur does not plan for this. Even if a business is able to turn a profit in the first year, more than likely its cash flow from profit will be negative, which means that making the profit will be a drain on the cash balance of the business.
Cash Flow from Profit in Start-Up Year
Business managers should understand that during a period of time, revenue and expense cash flows differ from accrual-basis accounting figures for revenue and expenses. This is especially important for the start-up year of a business. In its first year, a business has to build up its inventory of products for sale (assuming it sells products, of course). If the business extends credit to customers, it also has to build up its balance of accounts receivable, which is the amount of uncollected sales revenue. Both are cash sinkholes.
Inventory and accounts receivable are investments in assets, and these assets are needed for making sales. The cash outlay for inventory accumulation and the cash delay in collecting from credit sales are typically the biggest two factors affecting cash flow in the first year of business. There are other factors at play also.
The next table presents a combined P&L and cash flows report that discloses the cash inflow from sales and the cash outflows for expenses side by side with sales revenue and the expenses for the start-up year of our business example:
P&L Report Cash Flows Differences
Sales Revenue $1,200,000 $1,100,000 $(100,000)
Cost of Goods Sold (600,000) (680,000) (80,000)
Gross Margin $ 600,000
Expenses (120,000) (100,000) 20,000
Margin $ 480,000
Expense (50,000) 0 50,000
Other Fixed Operating-
Expenses (310,000) (330,000) (20,000)
Profit $ 120,000
Cash Flow (Negative) $ (10,000)
In the above table, depreciation expense is separated from the other fixed operating expenses of the business because depreciation is a unique expense from the cash flow point of view.
Caution: There’s no standard format for reporting revenue and expense cash flows internally to managers. Indeed, in many businesses, cash flows are not reported to managers—if you can believe it. You don’t see a report like the above table in external financial reports. The statement of cash flows must be included in the external financial reports of a business (to outside owners and creditors).
Most businesses use a different format for presenting cash flow from profit, which is called cash flow from operating activities. This format (not shown here) is in accordance with generally accepted accounting principles (GAAP) for external financial reporting. However, the information in the above table is much more useful for explaining cash flow from the profit-making (operating) activities of a business.
The idea of the above table is to make it easy to compare sales revenue and each expense in the P&L report with its corresponding cash flow for the year. Cash flows are matched with their accrual accounting basis figures in the P&L report. It is assumed that managers don’t have time to delve into all the technical details in the preparation of this report. It is the accountant’s job to analyze the accounts and to assemble a concise summary of the cash flows for revenue and expenses of the period.
The following is a brief overview, of why cash flows differ from the revenue and expense figures in the P&L report.
- Your year-end balance of accounts receivable is $100,000. You haven’t collected this money; your customers should pay early next year. So, you’re $100,000 short of cash inflow through the end of the year. Your cash inflow from making sales is $100,000 less than sales revenue for the year.
- You accumulated inventory of products held for sale. You purchased (or manufactured) more products than you sold during the year. Your out-of-pocket cash outlay during the year for the accumulation of inventory was $80,000. Your ending inventory is actually more than this amount; but through the end of the year, you hadn’t paid for your entire ending inventory. You have some accounts payable for inventory at the end of the year. The $80,000 is actual cash paid out for the build-up of your inventory.
- You did not pay 100% of your variable operating expenses recorded for the year. You have $20,000 of unpaid expenses at the end of the year, which is recorded as a liability (accounts payable). You’ll pay for these expenses early next year; but as of the end of the year, you had not written checks for $20,000 of your total variable operating expenses for the year.
- You bought and paid $500,000 for different fixed assets, which provide several years of use (a building, equipment, computers, and so on). The $500,000 cost is recorded in asset accounts; $50,000 of the total cost of these long-lived assets is recorded as depreciation expense in your first year. The $50,000 depreciation expense is not a cash outlay; you already made the cash outlay when you bought the assets. Therefore, the cash effect of recording depreciation expense is zero.
- Your net cash outlay for other fixed operating expenses was $20,000 more than the amount of these expenses for the year. You had to prepay certain of these costs. For example, you wrote checks for insurance policy premiums, but the coverage of these policies extends into next year. The portion of the premium cost that you have used up through the end of the year is recorded as an expense in the year.The asset account prepaid expenses holds back the remainder of the insurance premium cost, which will not be charged to expense until next year.
Adding up your revenue and expense cash flows for the year gives a $10,000 net decrease for the year. Making $120,000 profit “cost” you a $10,000 cash decrease through the end of the year. The $10,000 negative cash flow from profit is mainly the result of extending credit to your customers and building up your inventory, as just explained. Relative to your annual sales revenue and expenses, your cash flows look reasonable for a startup year.
You should have forecast the revenue and expense cash flows for your start-up year. The financial plan for the first year should have predicted these cash flows—in particular, that your profit would not provide positive cash flow during the first year. The negative cash flow means that you needed $10,000 cash subsidy from other sources. Evidently, you did a good job of planning for this. You raised $600,000 capital (see the second table previously), which leaves $90,000 cash balance as you start your second year of business.
“After the Start-Up Year” Scenario
As just discussed, the start-up year is very hard on cash flow from profit (see the above table again). In our start-up business example, the first year’s profit outcome is positive, but cash flow from profit is negative. This is not unusual for the start-up year of a business, during which it accumulates a stockpile of products (inventory) and extends credit to customers. A new business starts from zero and moves up to normal levels of inventory and accounts receivable.
A start-up business is an example of quick acceleration, or rapid growth. Generally speaking, rapid growth hinders cash flow; profit does not convert into cash flow during a high-growth year. Cash doesn’t flow in due to the accumulation of accounts receivable, and a good amount of cash outflow is needed to accumulate inventory of products held for sale.
In comparison, when a business has moderate or little growth, its profit and cash flows run much closer together—depending on the size of its annual depreciation expense (and any other non-cash expenses it records).
There are exceptions to this rule, of course. A moderate-growth, or no-growth business could let its accounts receivable and/or inventory get out of hand, either of which can cause a big dent in cash flow.
The next table shows a P&L and cash flows report for our business example based on the assumption of moderate sales growth for its second year.
P&L Report Cash Flows Differences
Sales Revenue $1,400,000 $1,380,000 $(20,000)
Cost of Goods Sold $ (700,000) (715,000) (15,000)
Gross Margin $ 700,000
Expenses $(140,000) (135,000) 5,000
Margin $ 560,000
Expense $ (50,000) 0 50,000
Operating Expenses $(370,000) (385,000) (15,000)
Profit (Net Earnings) $ 140,000
Cash Flow (Negative) $ 145,000
The example assumes that you kept your accounts receivable and inventory under control.
In other words, you made sure that these two assets increased only moderately, in proportion to your moderate sales growth. Depreciation expense is the same in the second year, which assumes that you did not purchase any additional fixed assets in the second year.
Notice that cash flow from profit in the second year is a little more than profit. In this situation, you have a pleasant problem facing you, one concerning what to do with your cash flow. Basically, you have four choices:
- Pay out some of the cash flow as a distribution of profit to owners;
- Let the cash stay where it is to build up your cash balance so that you can take advantage of opportunities in the future;
- Invest in new assets to expand the capacity of the business or to move in new directions; and
- Reduce the debt and/or equity capital base of your business. Positive cash flow provides a good deal of flexibility for a business.
Good business managers forecast cash flow from profit for the coming year. They don’t wait for the cash flow number to be reported to them in the financial reports for the year. They plan ahead so to provide enough lead time for making the critical decisions regarding what to do with the cash flow.
In summary, a business manager should closely monitor the differences between revenue and expenses in the P&L report and the cash flows of revenue and expenses during the period. The manager needs double vision, as it were, to keep on top of things.
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