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This can be a frustrating thing for small business owners…you and your team worked hard all year and your accountant tells your business made a “profit” – problem is, your bank account balance doesn’t reflect those profits or worse, you had to borrow from your line of credit or credit cards.
Truth is, profit doesn’t equal cash flow in a business. To find out if you made a profit or had a loss for the year, you look at the bottom line on your P&L (profit and loss) statement. Unfortunately, the bottom line on your P&L does not tell you cash flow from your profit-making activities.
Don’t ever assume that making profit increases cash the same amount. A business’s cash flow can be higher, or lower, than bottom-line profit. Cash flow can be negative when you earn a profit, and cash flow can be positive when you have a loss. There’s no natural or intuitive correlation between profit and cash flow.
The image below illustrates the differences between sales and expenses on your P&L and the cash flows of sales and expenses. For the purpose of this illustration, only three expenses categories are shown: cost of goods sold, depreciation, and one total amount for all other expenses. Please note that reporting expenses this way is not recommended or adequate but I did it in the interest of simplifying this example.
Here is an explanation of the cash flow differences in the chart:
- Your accounts receivable (from credit sales) increased $200,000 during the year, so actual cash collections from customers were only $1.8 million during the year — a cash flow shortfall of $200,000.
- You built up your inventory $50,000 during the year, so your cash outlays for products were $50,000 higher than the cost of goods sold expense for the year.
- Depreciation expense is not a cash outlay in the period recorded; the cash outlay took place when the fixed assets being depreciated were acquired in a prior period (possibly, some years ago).
- Total cash outlays for other expenses were $25,000 lower than the amount of expenses recorded in the year, mainly because your accounts payable and accrued expenses payable liabilities increased during the year — you had not paid this amount of expenses by year-end.
Every situation is different, of course. Cash flow isn’t always lower than profit for the year. Suppose accounts receivable had remained flat during the year; your cash flow would have been $200,000 higher. If you had not built up your inventory, then your cash would have been $50,000 higher at the end of the year, etc… you get the picture. You must keep close tabs on the changes in the assets and liabilities (found on your balance sheet) that impact cash flow from profit.
Need some tips on how to manage your cash? Check this blog out…