Agreed-Upon Procedures

My Organization is Profitable – Why Can’t I Pay Its Bills?

It’s common for profitable organizations to face challenges in meeting financial obligations, and if you find yourself in this situation, you’re not alone. A common misconception among leaders is to assume that profits directly translate into sufficient cash flow, which can result in shortfalls in the organization’s checking account. However, it’s important to recognize that there are numerous factors that can cause disparities between these two sets of numbers.

Fluctuations In Working Capital
Profits (or pretax earnings) are closely related to taxable income. Reported at the bottom of your organization’s income statement, they’re essentially the result of revenue earned minus operating expenses incurred in the accounting period. Under U.S. Generally Accepted Accounting Principles, organizations must ‘match’ costs and expenses to the period in which the related revenue is earned. It doesn’t necessarily matter when you pay for a product or service.

So, inventory items that are in progress or are completed but haven’t yet been sold can’t be deducted — even if they’ve been long paid for (or financed). The cost 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 receivables, accrued expenses, and payables — also represent a difference between the timing of cash outflows and the matching of expenses to sales. As organizations grow and prepare for increasing future sales, they need to invest more in working capital, which temporarily depletes cash.

Capital Expenditures & Financing Transactions
Working capital tells only part of the story, however. Your income statement also includes depreciation and amortization, which are noncash expenses. And it excludes capital expenditures and financing, which both affect your cash on hand.

To illustrate, suppose your organization purchased a new piece of equipment in 2022. Expanded bonus depreciation and Section 179 allowances permitted your company to immediately deduct the purchase price of the equipment, which lowered its taxable income for 2022. After making a modest down payment, the remaining amount of the purchase was financed with debt, so actual cash outflows from the investment were minimal in 2022. Throughout 2023, your organization has been making loan payments, and the principal repayment portion of these payments reduced the organization’s checking account balance but not its profits.

Capital Contributions, Dividends, & Stock Repurchases
You also can link discrepancies between profits and cash flow to owners’ equity accounts. For example, owners might pay out dividends based on their personal financial needs, regardless of whether the organization is profitable.

Dividends (or distributions) paid to owners lower cash on hand, but they have no effect on the profits reported on the organization’s income statement. Likewise, additional capital contributions and stock repurchases will hit the organization’s checking account without affecting profits.

Efficient Cash Flow Management
It’s important for leaders to understand the key differences between profits and cash flow. Some growing, profitable organizations will experience cash shortages. And some mature ‘cash cows’ will have ample cash on hand, despite lackluster revenue growth. If your organization is facing a cash crunch, contact us for help devising strategies to improve cash flow. We can help your organizations pay its bills on time and find resources to seize value-building opportunities.

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