Why Profits Do Not Always Lead to a Positive Cash Flow (and Vice Versa)

Net profits and a positive cash flow often go hand in hand, but not always. Some businesses report profits on the books while struggling to pay their bills each month. For your business to be successful, your management team must prioritize both profits and cash flow.

Cash Flow vs. Net Profit

It is important to track both cash flow and net profit because these two metrics calculate very different things.

Cash Flow

This term refers to the flow of cash into and out of an organization. A company reports a positive cash flow when its cash inflows exceed its cash outflows during a given period, and a negative cash flow when its cash outflows exceed cash inflows.

Net Profit

Net profit is the amount of earnings that remain after a business deducts associated expenses, such as taxes, costs of goods sold, depreciation, accruals, operating costs, and loan payments.

Net profit and cash flow both report figures that accumulate over a given period, but their inputs rely on different parts of the financial statement.

Cash Flow Calculation

Cash flow reports the change in cash and cash equivalents on the balance sheet over a specified period. Cash means the amounts held in currency and amounts held in checking and certain savings accounts. Cash equivalents are assets that are highly liquid, like certificates of deposit, treasury bills, money market instruments, stocks, and bonds. If businesses are in a pinch, they can quickly liquidate these assets and have almost immediate access to cash.

A cash flow statement breaks cash activity into three categories:

Operating Activities

This section details the cash activity that arises from the entity’s core business. Operating inflows might be sales receipts, collections on receivables, or receipts from insurance claims. Operating outflows might be payroll, rent, and inventory purchases.

Investing Activities

This section reflects the business’s cash activity related to its investment activity. Investing inflows might be sales of fixed assets or collection on loans, and investing outflows might be acquisitions of fixed assets or purchases of new stock investments.

Financing Activities

This section reflects cash that is generated or spent on activities that help fund the company’s operations. Financing inflows might be cash received from issuing equity or debt, and financing outflows might be dividend payments and stock repurchases.

A cash flow statement can be presented alongside the balance sheet and income statement to help the financial statement users assess how well the company manages its cash. Without the cash flow statement, users of the financial statements can see changes in cash balances, but they do not know where or how that cash is being used.

Net Profit Calculation

Net profit is reflected on the income statement. Net profit is calculated as follows:

It takes net profit to create cash at some point in time. When you get paid and when you pay your expenses drives when that net profit turns into cash. Consider revenue. When a business makes a sale, their customer can pay in cash or can promise to pay later. Either way, the business records revenue, but if a customer pays on credit, the business will not have an inflow of cash. They will instead record a receivable. Only when they collect on that receivable will there be a cash inflow. This timing difference is why users of the financial statements cannot glean information about a business’s cash activity by looking at its income statement.

In addition to timing differences, the income statement records items that may never have a direct corresponding cash effect. Consider depreciation, which is accrued monthly or annually on assets that a business owns. Depreciation reduces a business’s profit, but a business will not have a corresponding cash outlay for this expense.

Manage Your Business Using Both Metrics

Your business’s net profit calculation is important, but so is its cash position. By reviewing your cash activity regularly and forecasting your cash flow, your business will have a better chance at sustaining its successes. To learn more about how to use cash information to better manage your business, reach out to your CRI advisor.