Why Profit Does Not Equal Cash
WHY PROFIT DOES NOT EQUAL CASH
Why is profit not equal to cash coming in? Some differences such as loans received which do not impact the profit and loss statement are pretty obvious. Others may not be as obvious but you can break them down into three main areas:
- Revenue is booked at sale. In many cases a sale is recorded for accounting purposes in the profit and loss statement when a company delivers a product or service. In many cases, no cash has been exchanged at the time of sale since customers typically have a stated number of days to pay. So, since profit is partially determined by revenue, a component of that profit reflects a customer’s promise to pay. Cash flow reflects only cash actually received.
- Expenses are matched to revenue. An overriding accounting principle is to match the costs and expenses associated with the revenues generated during a given time period. The expenses charged to the income statement may not be those that were actually paid during that period. Many will be paid later when they are invoiced by a vendor. Cash flow reflects the cash that actually went out the door during a period.
- Capital expenditures do not count against profit directly. A capital expenditure does not appear on the income statement when it occurs. It is only the depreciation that is charged against revenue over time which is based on the useful life of the item that was purchased. The cash flow reflects a different story as most items are paid for long before they may be fully depreciated on the profit and loss statement.
It is true that in mature, well managed companies, cash flow will more closely track net profit. Receivables may be collected on a timely basis, payables will be paid, and capital expenditures will be incurred in line with depreciation charges. However, until an entity reaches, and more importantly is able to manage to, such a state, all sorts of havoc can take place. It is very easy to reach
Why is profit not equal to cash coming in? Some differences such as loans received which do not impact the profit and loss statement are pretty obvious. Others may not be as obvious but you can break them down into three main areas:
- Revenue is booked at sale. In many cases a sale is recorded for accounting purposes in the profit and loss statement when a company delivers a product or service. In many cases, no cash has been exchanged at the time of sale since customers typically have a stated number of days to pay. So, since profit is partially determined by revenue, a component of that profit reflects a customer’s promise to pay. Cash flow reflects only cash actually received.
- Expenses are matched to revenue. An overriding accounting principle is to match the costs and expenses associated with the revenues generated during a given time period. The expenses charged to the income statement may not be those that were actually paid during that period. Many will be paid later when they are invoiced by a vendor. Cash flow reflects the cash that actually went out the door during a period.
- Capital expenditures do not count against profit directly. A capital expenditure does not appear on the income statement when it occurs. It is only the depreciation that is charged against revenue over time which is based on the useful life of the item that was purchased. The cash flow reflects a different story as most items are paid for long before they may be fully depreciated on the profit and loss statement.
It is true that in mature, well managed companies, cash flow will more closely track net profit. Receivables may be collected on a timely basis, payables will be paid, and capital expenditures will be incurred in line with depreciation charges. However, until an entity reaches, and more importantly is able to manage to, such a state, all sorts of havoc can take place. It is very easy to reach