Profit doesn’t always mean cash in the bank, and here’s why:
We understand that many business owners run their businesses by keeping a watchful eye on their bank balance and/or a quick review of the Profit & Loss. This can work, but it doesn’t give owners a full picture of their business’ financial health. It also doesn’t account for items that are not recorded on the Profit & Loss – which can drain some serious cash. This can lead to situations where on paper the business is very profitable but is struggling to cover payroll each month.
So, what are the common reasons for this profit vs cash gap?
- Slow Customer Payments (Accounts Receivable)
If you’re accrual basis, profits could include sales that you have not received the funds for. If you sell $50k worth of goods on Net 60 terms, you’ll typically book these funds immediately. But you could potentially not see the cash in the bank from that transaction for several months.
- Owner Distributions
Owner Draws or Distributions never hit the Profit & Loss statement, so you won’t see them affecting your profit. You really must look at a combination of indicators before deciding how much you can afford to take out of the business – including profitability, cash flow, and bank balances.
- Capital Expenditures
A profitable business may invest in new equipment, technology, or make improvements to their buildings. These long-term investments are considered “Fixed Assets” and do not hit the Profit & Loss right away, instead, they are depreciated over time. So, you won’t see the negative effect on your profit immediately, but it will affect your bank balance.
- Debt Repayments
Your debt repayments do not show up on your Profit & Loss – only the interest portion of the payments. A different way to think about this is – when you receive a loan, you don’t book the loan as income, and consequently, you’re not booking the payments as expenses either. So, a company could be extremely profitable but be strapped for cash due to payables.
Consider a business with $1M in net profit. At first glance, that’s awesome! But there are other items to consider:
- They spent $2M on new assets
- They are waiting for $1.5M in customer payments
- The owners decided to take out $800k to reinvest elsewhere
These items are not visible on the Profit & Loss and might lead the owners to a false sense of security when the company is likely low on cash.
The items mentioned above are a few reasons why you could be showing a discrepancy between that Net Profit number and the cash in your bank account. In addition to these, you can also get into a “cash gap” situation, depending on how you are managing receivables, payables, and inventory. At the end of the day, profitability does not guarantee financial health for a business. It’s important to look beyond the Net Profit and the bank account balance – at the real bottom line.
If profitability vs cash is something you’re concerned about for your own business, get the strategic insight you need from our accounting advisor team today!
