Difference Between Profits and Cash Flows
One of the commonest misconceptions about business matters is that profit made by an organization is equal to, or roughly equal to, the increase in cash (or bank) balances recorded in a financial year. Many an investor who provides the capital for a company (by way of buying its shares) but plays no active role in its management finds it difficult to believe that his company has recorded a handsome profit in a particular year and yet it is in a net borrowing situation at the end of that year.
Erroneous as it might seem to an accounting student, it is not difficult to sympathize with a person holding this view. Not very long ago, many businesses dealt strictly in cash and if they ever needed to buy an asset, they always asked the owner to pay for it. In this way, their cash in hand was the net result of their business activities and roughly equal to their profits. However, the situation is much different today.
Profit, as disclosed by an Income Statement, represents the excess of revenue earned by a business over the expenses incurred by it, in a given financial period. The two important phrases are: revenue earned and expenses incurred. Now you are well aware that all revenue that is earned by a business may not necessarily be received by it in cash within the same accounting period; some revenue may be outstanding in the form of trade receivables at the year-end. On the other hand, some customers may have paid for their orders in advance. Such advance receipts do not form part of firm’s revenue earned.
Similarly, some of the expenses incurred in a period may not have been paid for in that period and may, therefore, appear in the closing balance sheet as accruals. Thus it is easy to see why profit disclosed by the Income Statement may not be equal to the cash generated by the business in a particular financial period. In fact, prepayments and accruals are not the only reasons for this discrepancy.
Just as all profit does not translate into cash, all cash receipts do not mean profit. For example, funds received as a loan increase the cash balance of a company but do not qualify to be called profit. Similarly, certain expenses, e.g. depreciation, may not result in cash outflow. And all payments may not necessarily be expenses, e.g. purchase of a fixed asset.
In Order to manage a business unit efficiently, its management needs to keep an eye on both profits and cash flows. Profits are controlled by preparation of budgeted income statements and regular preparation of actual income statements. A separate mechanism is needed to keep a watch on cash flows. This is achieved by periodically preparing a statement called Statement of Sources and Applications of Funds, or in short, Funds Flow Statement.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.