Business owners sometimes mistakenly equate profits with cash flow. Here is how this can lead to surprises when managing day-to-day operations and why many profitable companies experience cash shortages.

Working capital

Profits are closely related to taxable income. Reported at the bottom of your company’s income statement, they are essentially the result of revenue less the cost of goods sold and other operating expenses incurred in the accounting period.

The Generally Accepted Accounting Principles require companies to ‘match’ costs and expenses to the period in which revenue is recognized. Under accrual-basis accounting, it does not necessarily matter when you receive payments from customers or when you pay expenses.

For example, inventory sitting in a warehouse or retail store cannot be deducted even though it may have been long paid for (or financed). The expense hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.

Other working capital accounts — such as accounts receivable, accrued expenses, and trade payables also represent a difference between the timing of cash flows. As your business grows and prepares for increasing future sales, you invest more in working capital, which temporarily depletes cash.

The reverse also may be true. That is, a mature business may be a ‘cash cow’ that generates ample cash, despite reporting lackluster profits.

Capital expenditures, loan payments, & more

Working capital tells only part of the story. Your income statement also includes depreciation and amortization, which are non-cash expenses. And it excludes changes in fixed assets, bank financing, and owners’ capital accounts, which affect cash that is on hand.

To illustrate: Suppose your company uses tax depreciation schedules for book purposes. In 2018, you purchased new equipment to take advantage of the expanded Section 179 and bonus depreciation allowances. The entire purchase price of these items was deducted from profits in 2018. However, these purchases were financed with debt. So, actual cash outflows from the investments in 2018 were minimal.

In 2019, your business will make loan payments that will reduce the amount of cash in the company’s checking account. But your profits will be hit with only the interest expense (not the amount of principal that is being repaid). Plus, there will be no ‘basis’ left in the 2018 purchases to depreciate in 2019. These circumstances will artificially boost profits in 2019 without a proportionate increase in cash.

Look beyond profits

It is imperative for business owners and management to understand why profits and cash flow may not sync. If your profitable business has insufficient cash on hand to pay employees, suppliers, lenders, or even the IRS, contact us to discuss ways to more effectively manage the cash flow cycle.