Cash Flow vs Profit

The financial projections template includes both an income statement and a cash flow statement. There is often confusion between the profit shown in the income statement and the cash flow shown in the cash flow statement.

It is important to understand that cash and profit are not the same thing. A business cannot assume that just because it is profitable that it has the cash to survive. Let’s take a look at an example.

Cash Flow vs Profit Example

Suppose a business is considering taking on a contract which will take two months to complete. The value of the contract is 9,000, labor and material costs are expected to be 5,000, and operating expenses 1,000. The business is therefore expected to make a profit calculated as follows.

Profit = Revenue - Cost of goods sold - Operating expenses
Profit = 9,000 - 5,000 - 1,000 = 3,000

Profit

During the first month no revenue is earned but costs are incurred and carried as part of inventory. In month 2 the balance of the costs are incurred, the contract is completed and the customer is invoiced for the full contract value.

The business would prepare income statements for month one and two as follows:

In month 1 the business incurred costs of 4,800. The amount relating to direct costs for labor and materials of 4,000 is included as part of the inventory of the business. The operating expenses of 800 are treated as an expense and the business shows a loss of 800.

In month 2 the contract is completed, the customer is invoiced for the contract value and revenue is therefore 9,000. The total cumulative direct costs of 5,000 are now matched to the revenue under the heading cost of sales, and after additional operating expenses for the period of 200, the business shows a profit of 3,800.

Over the two months the business has made the expected profit of 3,000 which is the month 1 loss of 800 plus the month 2 profit of 3,800.

Cash Flow

Now consider what happens to the cash flow of the business as a result of this contract. Suppose the customer is given credit terms and is allowed to pay invoices after 60 days. Suppliers for labor and materials are paid 30 days after the end of the month, and operating expenses are paid 50% in cash and 50% after 30 days.

Using this information, the business would prepare cash flow statements as follows:

The contract is completed in month 2 and the customer is invoiced and pays after 60 days at the end of month 4. Suppliers for labor and materials are paid after 30 days at the end of the following month. Operating expenses are part (50%) paid in cash in the month in which they are incurred with the balance paid after 30 days at the end of the following month.

Difference Between Cash and Profit

The table below shows the cash flow vs profit for the business for the four months.

Notice that the cumulatively profit and cash flow at the end of the four months are the same and total 3,000.

Profit = -800 + 3800 + 0 + 0 = 3,000
Cash flow = -400 - 4,500 - 1,100 + 9,000 = 3,000

The cumulative profit and cash flow at the end of each month is summarized in the graph below.

From the above table and graph it is clear that profit and cash flow are not the same thing. At the end of month 2 the business is profitable and for the two months has made a profit of 3,000, looking at the income statement, the business might conclude everything is fine. However, the cash flow statement shows a different story, at the end of month 2 the cumulative cash outflow from the business is -4,900, and by the end of month 3 this increases to -6,000. At this stage cash is flowing out of the business and unless adequate funding is made available, the business will fail when it runs out of cash and is unable to pay its bills, even though it is a profitable business.

By the end of month 4 the customer pays the invoice for the contract value of 9,000, and the cash flow improves and becomes positive reaching a total of 3,000, the same as the profit.

Summary

Simply looking at the income statement and the profit of the business is insufficient, it only shows part of the story. It can be seen that in this example the difference between cash flow vs profit is one of timing, with cash being tied up in working capital (inventory) as the contract progressed.

The profit is made within the first two months and the cash flow is paid and received over four months. It is important therefore when preparing financial projections to allow for this timing difference by adjusting the number of inventory days, accounts receivable days, and accounts payable days.

In addition to this the income statement does not show all the payments the business makes. For example cash spent on investment in property, plant and equipment, dividend payments or debt repayments are not included in the income statement and are therefore not reflected in the profit of the business.

A business must eventually be able to make a profit, however, providing it is properly financed and has adequate cash flow a business can survive for a considerable period of time without profits. As the saying goes ‘Cash is King’.