Profit vs Cash Flow: Why a Profitable Business Can Run Out of Money

Profit measures what a business earned and spent in a period, recorded when the earning and spending happened. Cash flow measures money actually moving. Profit and cash flow differ for three reasons. Non-cash charges reduce profit and move no money. Money is spent on things that are not costs. Customers and suppliers pay on their own schedules. A business can be genuinely profitable and still end the year with less money than it started with.

Here is what sits underneath that. Profit answers whether a year of trading created value: did the business sell things for more than they cost to make and sell. Cash answers whether the business can pay for what it has promised to pay for next week. Value and next week's payment are two different questions, so they get two different numbers, and no rule of accounting or of arithmetic requires the two answers to match. The gap between them is not an error, not a sign of trouble, and not something anybody is hiding. The gap is the ordinary consequence of measuring two different things.

Both measures can be defined without either one reaching for the other. Every gap that ever appears between them has three structural causes, growth pushes the gap in a direction that is known before a single figure is seen, and a real gap of Rs 32,00,000 comes apart into named parts that add back to exactly Rs 32,00,000 with nothing left over and nothing unexplained.

What is profit, measured exactly, and what does it leave unanswered?

Profit is revenue for a period less every cost that belongs to that period. The words that carry all the weight are belongs to that period. Under the accrualThe basis on which financial statements are prepared, where a sale is recorded when the goods or services are delivered and a cost is recorded when it is incurred, whether or not money has moved. basis, a sale is recorded when the goods go out of the door, not when the money comes in, and a cost is recorded when it is incurred, not when the supplier is paid. So profit is a statement about the trading of the year, deliberately detached from the calendar on which money happens to move.

Profit is the answer to one question only: did this year of trading create value, once every cost that belongs to the year has been counted against it. Consider a household with one earning member. In March the salary is credited, the rent is paid, the school fee is paid, the electricity bill for February arrives and is paid in March. Whether that household lived within its means in March is answered by counting February's electricity against February and March's against March, even though both were paid in March. Counting each bill against its own month is accrual thinking, and everybody does it instinctively when a fair answer about a month is wanted. Profit is the same instinct, written down under rules.

Anjani Stationers, an invented notebook business, records revenue of Rs 2,70,00,000 in year two and works down to profit after tax of Rs 30,00,000. The ladder below shows what happens at each rung: earnings before interest, tax, depreciation and amortisation of Rs 53,50,000, then depreciation and amortisation of Rs 12,00,000 taken off to reach Rs 41,50,000, then the finance cost of Rs 3,50,000 to reach profit before tax of Rs 38,00,000, then tax of Rs 8,00,000 to reach Rs 30,00,000. Every one of those subtractions is a cost that belongs to year two. Not one of them is a statement about when money moved.

Profit does not say whether any of it is available. Availability is a question about a bank account, and profit was never a measurement of a bank account. A business can post its best profit ever in the same week it cannot pay a supplier, and both facts can be entirely correct at once. The pairing is not a paradox and it is not a warning sign on its own. Somebody asked a question about value and then read the answer as though it had been a question about money.

What is cash flow, measured exactly, and what does it leave unanswered?

Cash flow is the movement of money in and out of the bank and the cash box over a period. There is no judgement in it and no rule to apply. A rupee either arrived or it did not. Printing the bank statement for the whole year and adding up every credit and every debit arrives at the same net movement the cash flow statement reports. The cash flow statement is therefore the one statement that can be checked against a document produced by somebody outside the business.

Cash flow answers a single question that profit never touches: can this business pay what it has to pay, on the dates it has to pay it. Return to the household. The salary arrived on the first, the rent went out on the fifth, the school fee on the tenth. Whether the household lived within its means in March is one question; whether there was money in the account on the tenth is a completely separate one, and everybody who has ever juggled a fee date knows it. A household can be perfectly within its means for the year and still be short on the tenth. Businesses are the same, only the amounts are larger and the dates are somebody else's to choose.

Anjani Stationers opened year two with Rs 7,00,000 in the bank and closed with Rs 5,00,000. A fall of Rs 2,00,000 is the whole of cash flow for the year. Underneath that small movement, though, very large amounts came and went. Operating activities produced Rs 36,30,000. Investing took Rs 34,00,000 out. Financing took a further Rs 4,30,000. The net of those three is minus Rs 2,00,000, exactly the difference between the two bank balances. The small net movement hides three big ones, and the statement is worth reading for exactly that reason.

Cash flow does not say whether the year was any good. A year of heavy spending on things that will earn for a decade looks identical, in the cash movement alone, to a year of losing money. Both show cash going down. A business that spends Rs 34,00,000 on machines and a business that loses Rs 34,00,000 on bad trading can post the same fall in the bank balance, and only the profit figure separates them. Neither number is allowed to replace the other for exactly that reason, and every set of accounts carries both.

What exactly creates the gap between profit and cash?

Three things, and only three. With those three in hand, every gap decomposes into them without a residue. The two panels below are laid out identically, and the differences between them are the only thing visible. Same period, same business, same set of transactions underneath, two measurements that do not agree because they were never measuring the same thing.

Cause one: charges that reduce profit and move no money

Some costs are real, belong to the year and must be counted against it, and yet no rupee leaves the bank when they are recorded. A non-cash chargeA cost recorded against profit for a period where no money leaves the business at the time it is recorded, such as depreciation on equipment already paid for years ago. is exactly that. Depreciation is the clearest one. The machine was paid for once, in the year it was bought, and the cost of using it is then spread across the years it works. Every one of those later charges reduces profit and moves nothing.

Anjani Stationers charged Rs 19,80,000 of costs against profit in year two that moved no money at all, so on this cause alone cash was better off than profit by that amount. Take the three apart. Depreciation and amortisation of Rs 12,00,000 relates to equipment and software already bought and paid for. A provision for doubtful debtsAn amount taken off what customers owe, to reflect the part the business no longer expects to collect. The provision reduces profit when it is taken, even though no money has left. of Rs 6,00,000 was charged, being the movement from Rs 3,00,000 to Rs 9,00,000, and it is an expectation about money that may never arrive rather than money that left. And Rs 1,80,000 of the Rs 8,00,000 tax charge is deferred taxTax charged against this year's profit that becomes payable in a later year, because the rules for computing taxable profit differ in timing from the rules for computing accounting profit., tax charged against this year's profit and payable later. The tax actually paid in year two was therefore Rs 6,20,000.

Cause two: money that leaves without ever being a cost

The mirror image. Buying something is not spending something, so some payments are very real, very large, and never appear anywhere in the profit figure. When a business pays for a machine, no cost has been incurred yet: an asset has changed form, from money into equipment. The cost arrives later, spread over the years the machine works, as the depreciation of cause one. Repaying a loan is the same shape. A repayment is not a cost, so money leaves, an obligation shrinks, and profit is untouched.

Anjani Stationers paid out Rs 35,00,000 during year two on things that never reduced its profit by a single rupee, and received Rs 20,000 that never increased it. The payments were Rs 12,00,000 for property, plant and equipment, Rs 1,00,000 for software, Rs 21,00,000 for the 70 per cent holding in Chitra Binding Works, and Rs 1,00,000 of lease principal repaid. The receipt was Rs 20,000 of net new term loan drawn, money in the bank and not income. Net on this cause, cash was worse off than profit by Rs 34,80,000. Notice that the interest of Rs 3,50,000 is not on this list: interest genuinely is a cost, it reduced profit, and it was paid in cash in the same year, so on the interest the two measures agree exactly and it contributes nothing to the gap.

Cause three: everything arrives and departs on somebody else's schedule

The third cause is pure timing. Unlike the first two there is nothing conceptual to grasp, and that is exactly why it catches people. A sale was made and recorded, and the customer simply has not paid yet. Paper was bought and used, and the supplier simply has not been paid yet. Each of those is a timing differenceA difference that arises only because a transaction is recorded in one period and the money for it moves in another, so it reverses by itself once the money moves.: the profit and the money are the same event, separated in time, and the difference reverses by itself when the money finally moves.

Follow one order through, using assumed figures for a single order so the shape is visible. The Sunrise Public School group places an order worth Rs 4,00,000. Anjani Stationers buys paper and board for it and pays for them, assumed at Rs 2,60,000. Then the notebooks are bound and delivered, and at that moment the sale of Rs 4,00,000 and the profit of Rs 1,40,000 go into the accounts. Then, later, the school pays. Between the delivery and the payment, the profit is fully recorded and the money is entirely absent, and the amount sits in receivables in the meantime.

Across a whole year, timing shows up as the movement in the balances that sit between a transaction and its money, and at Anjani Stationers those balances absorbed Rs 17,00,000 net during year two. Four balances moved. Receivables gross rose Rs 17,00,000, from Rs 78,00,000 to Rs 95,00,000, money earned and not yet collected. Inventory rose Rs 9,00,000, from Rs 19,00,000 to Rs 28,00,000, money spent on paper and board that has not yet become a sale. Working the other way, trade payables rose Rs 7,00,000, the business holding on to suppliers' money for longer, and the contract liabilityMoney a customer has already paid for goods or services not yet delivered. The business owes the delivery, so the money is shown as a liability and not as revenue. rose Rs 2,00,000, schools' money already received for notebooks not yet delivered. Add the four: minus 17, minus 9, plus 7, plus 2, giving a net absorption of Rs 17,00,000.

Why is the gap widest in a business that is growing?

Because growth is bought before it is paid for. Every extra rupee of sales starts life as extra paper on the shelf and extra invoices outstanding, and both of those have to be funded out of money the business already has, weeks or months before the customer's payment arrives. A shop that sells the same amount every year funds nothing extra: what came in last month pays for what goes out this month, and the balances sit still. A shop growing at a fifth a year has to find the funding for a fifth more stock and a fifth more unpaid invoices, every single year, out of a profit that is only a small slice of the sales.

Growth makes the gap wider, and it does so through cause three alone. A widening gap is therefore evidence of expansion at least as often as it is evidence of trouble. That sentence cuts both ways. A business whose gap is widening year after year while sales climb is behaving exactly as arithmetic says it must. The same widening gap with flat sales is a different animal entirely and would need explaining. The gap on its own says nothing until what the sales did has been established.

Anjani Stationers is the case in miniature. Revenue grew 12.5 per cent in year two, from Rs 2,40,00,000 to Rs 2,70,00,000. Receivables gross grew 21.8 per cent, from Rs 78,00,000 to Rs 95,00,000. Inventory grew 47.4 per cent, from Rs 19,00,000 to Rs 28,00,000. The balances that have to be funded grew faster than the sales that fund them, and that is the whole of the mechanism. The chart below holds Anjani Stationers' cost structure and its investing and financing steady, and moves only the growth rate, so the two lines can be seen parting.

At zero growth, profit is Rs 26,66,667 and cash rises by Rs 11,66,667, a gap of Rs 15,00,000 made entirely by the first two causes. At 10.5 per cent growth cash is barely still positive at Rs 18,667, and by 11 per cent it has turned to minus Rs 36,000. At the actual 12.5 per cent, profit is Rs 30,00,000 and cash is minus Rs 2,00,000. At 20 per cent, profit is Rs 32,00,000 and cash is minus Rs 10,20,000. At 40 per cent, profit is Rs 37,33,333 and cash is minus Rs 32,06,667. Across that whole stretch profit improves by Rs 10,66,666 while the cash movement worsens by Rs 43,73,334. The whole lesson is in those two numbers. Press the freeze button at the starting position and the cash movement jumps from minus Rs 2,00,000 to plus Rs 15,00,000, a swing of exactly the Rs 17,00,000 the balances had absorbed, with profit completely unchanged at Rs 30,00,000.

Which measure matters more, and when?

Neither, permanently. Each is the more useful of the two for a particular question, and the mistake is never using the wrong measure knowingly, it is reaching for whichever number is at hand. Profit is the figure in the headline, the figure in the conversation, the figure people give when asked how the year went, so profit is at hand far more often. Cash usually has to be looked up. Most of the trouble comes from that asymmetry rather than from any confusion about the concepts.

Use cash for any question about the next few weeks and profit for any question about whether the business itself works, and never let one of them answer for the other. Can wages be paid on the first: cash, and nothing else will do. Is this business worth continuing in its present shape: profit. A business can generate cash for a year or two simply by not replacing anything. Will the bank facility be repaid on schedule: cash. Is the pricing right: profit. A business is solventHolding more than it owes, and so able to meet its obligations in full over time. A business can be solvent and still be unable to pay a bill due this week. when what it holds exceeds what it owes. A business has liquidityThe ability to pay what is due right now, which depends on money being available at the moment it is needed rather than on the business being sound overall. when the money is actually there on the day it is needed. The two are entirely capable of parting company.

How big was the gap at Anjani Stationers, and what made it?

Profit after tax was Rs 30,00,000. Cash fell by Rs 2,00,000. The distance between those two statements about the same twelve months is Rs 32,00,000, and every rupee of it has a name. Work down the bridge below one step at a time. The bridge starts at the profit figure, applies each adjustment in the order the cash flow statement applies them, passes through Rs 36,30,000 of net cash from operating activities, the figure the statement itself publishes, and lands on the fall of Rs 2,00,000 that the two bank balances confirm.

Read the four subtotals and notice what is not in the list: there is no line for a mistake, no line for anything unexplained, and no line for money that went missing. Rs 19,80,000 was charged and never paid. Rs 34,80,000 was paid and never charged. Rs 17,00,000 was the right amount landing in the wrong period. The interest was charged and paid in the same year, the two measures agree on it exactly, and it contributes nothing at all. Plus 19,80,000, less 34,80,000, less 17,00,000 gives less 32,00,000, and Rs 30,00,000 less Rs 32,00,000 is minus Rs 2,00,000. The two ends meet, and that is the only proof that nothing has been left out.

How does a lender read the two numbers together?

Step out of the classroom. This pairing is not an idea people admire. The pairing is a reading somebody performs in a room where a facility is granted or refused, and a lender looking at Anjani Kulkarni's year two accounts moves through it in a fixed order. Each question only makes sense once the previous one has been answered, so the order matters more than any single figure in it.

A lender asks whether the trading worked, then whether the trading produced money, then where the money went, and only then what any of it means for lending, and the fall in the bank balance is the last thing looked at rather than the first. Question one: did the year work. Profit after tax of Rs 30,00,000 on revenue of Rs 2,70,00,000, so yes. Question two: did the trading turn into money. Net cash from operating activities of Rs 36,30,000, more than the profit, so yes and comfortably. Question three: where did the money go. Rs 34,00,000 into equipment, software and a 70 per cent holding in another business, money converted into assets rather than money consumed. Question four: what does that mean. The business is sound, the year's spending was a decision rather than a loss, and the thing to watch is that the cushion left in the bank is Rs 5,00,000 against year two operating cash of Rs 36,30,000.

Notice what the sequence protected the lender from. Reading the fall of Rs 2,00,000 first would have suggested a business going backwards, and it is not. Reading the profit of Rs 30,00,000 alone would have suggested Rs 30,00,000 of headroom, and there is not. Neither number was allowed to speak on its own, and the four questions took about ten minutes.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.