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Financial Reporting

The Difference Between Profits & Cash Flow

Profitable organizations often experience cash flow shortages, especially if they’re experiencing rapid growth. Business owners may wonder why they owe taxes when they regularly struggle to find cash to cover their bills. In understanding the key differences between profits and cash flow, the answer can be found.

Operating Activities 

Profits are closely related to taxable income. Reported at the bottom of your organization’s income statement, they’re essentially the result of revenue less the cost of goods sold and other operating expenses incurred in the accounting period. U.S. Generally Accepted Accounting Principles require organizations to “match” costs and expenses to the period in which revenue is recognized. Under accrual-basis accounting, it doesn’t necessarily matter when you receive payments from customers or when you pay expenses.

For example, retailers and manufacturers can’t deduct unsold inventory, even though it may have been paid for (or financed) long ago. The expense (cost of goods sold) 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 in the timing of cash flows. As your organization grows and prepares for increasing sales, you invest more in working capital, which temporarily depletes cash.

For mature organizations, the reverse situation may happen. That is, they may be “cash cows” that generate ample cash despite reporting lackluster growth and profits.

Financing & Investing Activities

Working capital items tell only part of the story. Your organization’s income statement also includes depreciation and amortization, which are noncash expenses. It excludes changes in fixed assets, bank financing, and owners’ capital accounts, which affect cash that’s on hand.

For instance, suppose your organization uses tax depreciation schedules for book purposes. In 2023, you purchased new equipment to take advantage of the expanded Section 179 allowance. The entire purchase price of these items was deducted from profits in 2023. However, these purchases were financed with debt. So, actual cash outflows from the investments in 2023 were minimal.

In 2024, your organization will make loan payments that will reduce the amount of cash in the organization’s checking account. But your profits will be hit with only the interest expense (not the principal amount being repaid). Plus, there will be no “basis” left in the 2023 purchases to depreciate in 2024. These circumstances will artificially boost profits in 2024, without a proportionate increase in cash.

We Can Help

When budgeting and overseeing organizational finances, owners need to look beyond profits to avoid cash flow crises. Contact us to discuss ways to manage the cash flow cycle more effectively.

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