One of the most common misconceptions about business is that the profit an organization makes is equal to—or roughly equal to—the increase in cash (or bank) balances recorded in a financial year.

Many investors who provide capital for a company (by purchasing shares) but are not managerially active find it hard to believe that their company has recorded a 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. 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 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 in cash within the same accounting period; some revenue may be outstanding in the form of trade receivables at year-end.

On the other hand, some customers may have paid for their orders in advance. Such advance receipts do not form part of the 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.

Hence, with these examples in mind, it is easy to see why profit disclosed in an income statement may not equal the cash generated by the business in a 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 equate to profit. For example, funds received as a loan increase the cash balance of a company but do not qualify as 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 preparing budgeted income statements and regularly preparing actual income statements. A separate mechanism is needed to keep a watch on cash flows.

This is achieved by periodically preparing a statement called a statement of sources and applications of funds (or, in short, a Fund Flow Statement).

Frequently Asked Questions

What is a profit?

A profit is an increase in the wealth of a business. It is shown as an addition to the owner's equity on the right-hand side of the balance sheet.

What are examples of profits?

Profits can be from selling a product, investing in other businesses, or as a result of the business itself.

What is a cash flow?

Cash flow is the total amount of cash that a company generates or uses over a period. It may be used for investment purposes, debt repayments, etc.

What are examples of cash flow?

Examples of cash flow include money borrowed to pay bills and tax payments as well as dividends paid to shareholders. The net change in accounts receivable also affects cash flow.

What are the differences between profit and cash flow?

Profit is determined by the excess of total revenue over total expenses. Cash flow, on the other hand, is equal to net profit plus depreciation minus changes in non-cash assets.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

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