People often mistakenly believe that a cash flow statement will show the profitability of a business or project. Although closely related, cash flow and profitability are different. Cash flow represents the cash inflows and outflows from the business. When cash outflows are subtracted from cash inflows the result is net cash flow. Profitability represents the income and expenses of the business. When expenses are subtracted from income the result is profit (loss). You may think of cash flow as transactions that affect your business "checkbook" and profitability as items that impact your "income tax return".
Cash inflows and outflows show liquidity while income and expenses show profitability. Liquidity is a short-term phenomenon: Can I pay my bills? Profitability is a medium-term phenomenon: Am I making money? Cash flow (liquidity) is represented in a cash flow statement while income and expenses (profitability) are represented in an income statement.
Many income items are also cash inflows. The sales of products by the business are usually both income and cash inflows (cash method of accounting). The timing is also often the same as long as a check is received and deposited in your account at the time of the sale. Many expenses are also cash outflow items. The purchase of ingredients and raw materials (cash method of accounting) are both an expense and a cash outflow item. The timing is also the same if a check is written at the time of purchase.
However, there are many cash items that are not income and expense items, and vice versa. For example, the purchase of a capital asset, such as a machine, is a cash outflow if you pay cash at the time of purchase as shown in the example in Table 1. Because the machine is a capital asset and has a life of more than one year, it is included as an expense item in an income statement by the amount it declines in value each year due to wear and obsolescence. This is called "depreciation." In the tables below, a $70,000 machine is depreciated over seven years at the rate of $10,000 per year. Because the machine is completely depreciated over the seven-year period (is shown to have no remaining value) but sold for $15,000 at the end of year 10, $15,000 of depreciation needs to be repaid (depreciation recapture). This is additional income in year 10.
Depreciation calculated for income tax purposes can be used. However, to more accurately calculate profitability, a more realistic depreciation amount can be used to approximate the actual decline in the value of the machine during the year.
In the example in Table 1, a $70,000 machine is purchased and used for 10 years, at which time it is sold for $15,000. The net cash outflow and depreciation expense are both $55,000, although the cash flow transactions are just at the beginning and ending of the period, while the depreciation expense is spread over most of the 10-year period. So the impact on annual operations from the purchase of the machine is considerably different depending on whether you are focusing on liquidity or profitability.
If money is borrowed for the purchase of the machine, the cash outflows and expenses are different from those in Table 1. In this situation, the down payment is a cash outflow at the time of purchase and the annual debt payments (principal and interest) are cash outflows over the term of the loan as shown in Table 2. The total cash outflow is $65,500 in this example versus $55,000 in Table 1 in which no funds are borrowed. The additional $10,500 of cash outflow is the interest payments.
When money is borrowed to finance the purchase of the machine, the amount of interest paid on the loan is included as an expense along with depreciation. Interest payments are an expense because they represent the cost of borrowing money. Conversely, principal payments are not an expense because they are merely a cash transfer between lender and borrower. The total expense is $65,500 in this example versus $55,000 in Table 1 in which no funds are borrowed. The additional $10,500 of expense is interest payments.
Once again the net cash outflow and expense of the machine in the example in Table 2 are the same ($65,000). However, the timing of the cash outflows and expenses are different over the 10-year period. So the impact on annual operations from the purchase of the machine is considerably different depending on whether you are focusing on liquidity or profitability.
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Don Hofstrand, retired extension value added agriculture specialist,
Cash flow is often a problem in small businesses, but it’s even harder to understand if your business is profitable. In fact, many profitable businesses will go out of business because they don’t have enough cash to fund the business.
Profit does not equal cash: it is as simple as that! Profit is made after you have made sales and paid all expenses. Of course, you will have to pay tax on the profit as well. The remaining amount is then reinvested back into the business or distributed the owners.
Cash is what the business needs to operate every day. Cash can come from different sources — profit is one — but you can also generate cash for the business by selling assets, contributing your own personal funds, using bank loans or seeking new investors.
Spend at the right time
The key to remember is that we don’t spend profit in our business — we spend cash, and it is all in the timing. Firstly as the old saying goes, you have to spend money to make money. To make a profit, you first need to purchase goods or services to sell, so you will need cash before the sale is made. By selling your product or service at a higher price than what it cost, you make a profit. The point is you need the cash before you get the profit.
The second timing problem — the one that catches most businesses — is providing credit to customers. The longer the customer takes to pay, the longer you have to wait for the cash, and in the meantime you have wages, rent, stock and other expenses to pay. This is where the trouble begins and often ends.
Focus on what matters
You need to focus on not only profit but also what drives your cashflow. If you have regular loan repayments, rent and other expenses that have to be made on time, then you will need enough cash to cover these while you wait for your customers to pay. Keeping track of your accounts receivable and following up on late payments will definitely help your cashflow. The other thing to remember is if you can get credit from your suppliers, this may mean that you don’t have to pay for stock until you have sold it — again making a big difference to your cash flow.
A business will need to be profitable to stay in business, so we also have to be weary of sacrificing profits to generate cash. Offering discounts to pay early will definitely help your cash position but will reduce your profit. To alleviate the conundrum of cash versus profit, it is best to make sure you have enough cash stashed to cover ongoing expenses. You may consider having a finance facility in place that will tide you over during a cash flow shortage, but this will cost in the form of fees and interest, which will reduce your profit.
Just remember, 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.
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Say you are a retailer and collect cash at sale. Your expenses may be paid to vendors at a later time which may lull an owner into a false sense of health. The cash flow statement may look fine as the business is growing, but if margins and expenses are poorly managed, the owner may find themselves in an unprofitable situation which cannot perpetuate a healthy business. What Are the Differences Between Straight Line, Double-Declining Balance & Units of Production?
Depreciation is the allocation of an asset’s cost over its useful life. A company may choose from different methods of depreciation for financial reporting purposes. Straight line, double-declining balance and units of production are three such methods. Each method differs in the way it allocates an asset’s cost, which can affect your small business’ profit.Purpose of Depreciation
Accrual-based accounting requires a business to match the expenses it incurs with the revenues it generates each accounting period. Because a long-term asset, such as a piece of equipment, contributes toward revenues over many accounting periods, a company spreads the asset’s cost over its useful life using depreciation. This creates a depreciation expense on the income statement each accounting period equal to a portion of the asset’s cost instead of creating an expense for the entire cost all at once.