Profit vs. cash – The difference
Although a key reason for business failure can be attributed to running out of cash, many investors and businesses do not give due attention to this. It is critical to understand that profit does not equal cash flow in a business. They are not the same. It really does not matter if sales, profits and assets increase if there is no cash to continue. Depreciation, loans and loan repayments are a few examples of factors that only affect either profit or cash flow but not both. Hence, to succeed it is critical to understand the difference between the two.
Profit
In simple terms, profit is the surplus income over expenses. In reality, income and expenses may not be in actual cash. For example, if a business sells on credit, it is considered to be generating revenue (income) even though cash is not received immediately. Similarly, there may be expenses which are not paid immediately but are recognised as expenses and should be paid in the future from earnings. Thus, profit is commonly calculated using non-cash transactions. This fundamental model is known as the accruals concept, which states that transactions are logged when they take place rather than when payments are received or paid. For these reasons, a profit and loss (P&L) account provides an insight into the profitability of a business, but it says very little about the actual cash position.
Cash
Many businesses set objectives for profits and neglect cash. Cash flow is the actual money coming in and going out of the business. It is imperative to have cash to meet day-to-day obligations, such as procurement of supplies, creditors, staff commitments, etc. Thus, businesses should prepare a cash flow budget and statements to control and monitor their cash position – but astonishingly many still do not.
Balancing act
Profit and cash flow may sometimes be contradictory metrics. For instance, to increase profitability a business may have to sell on credit. On the other hand, to improve cash flow businesses may have to offer a discount for cash customers.
A business cannot run out of cash but nor should it have an unprecedented cash balance lying around doing nothing. Thus, a successful business needs to strike a balance between profit and cash and maintain the appropriate amount of cash. Although profit and cash are not the same, in the long run profits should and do turn in to cash. For public/listed companies, publishing a cash flow statement along with the Balance Sheet and P&L account is mandatory – this emphasises the significance of cash flow as it allows intelligent assessment of the business. Yet, it is common for investors and businesses (especially small businesses) to focus solely on profits and neglect cash flow. What they fail to understand is that profitability is a measure of success whilst cash flow is survival. Thus, survival should have priority over profit simply because a business cannot be profitable without surviving. Profit is important but cash is too. After all, ‘cash is king’.
(The writer is a Sri Lankan
professional based in the UK).