Why a company’s profit is not its cash balance

The short answer

Profit is measured on the accrual basis: the effects of transactions are recognised in the period in which they occur, even if the cash is received or paid in another period. Revenue is recognised when the customer obtains control of the goods or services, which can be well before payment. The cash balance changes only when money actually moves. The two numbers answer different questions, so they are rarely equal.

The example

In the first month of our invented company, the one in the income statement and balance sheet article, the profit was 400, yet operating activities used 500 of cash. Three timing differences explain it:

• The company sold goods for 2,400 but collected only 1,000. The other 1,400 is still owed by the customer (accounts receivable).
• It bought goods for 4,000 but sold goods costing only 1,500. The remaining 2,500 of stock is a cost that is not in profit yet, because those goods have not been sold.
• It paid the supplier only 1,000, so 3,000 of the purchase is still unpaid (accounts payable). That delays cash going out and offsets part of the stock increase.

The owner’s 10,000 is financing, not income, so it is shown below the operating line. Cash ends the month at 9,500.

How IAS 7 presents it

IAS 7 classifies cash flows into operating, investing and financing activities. For operating activities it permits the direct method, which shows gross receipts and payments, or the indirect method used above, which starts from profit or loss and adjusts for non-cash items and for timing differences in receipts and payments.

What to watch

• How long customers take to pay compared with how long you take to pay suppliers.
• Stock that grows faster than sales.
• Growth: more sales usually need more stock and more credit given to customers before the cash arrives, so a profitable, growing company can still run short of cash.

In TexaCore

This section describes the product. The statements TexaCore shows on screen are the trial balance, the income statement and the balance sheet; the bridge above is a manual calculation to explain the logic. To look at the pieces in the application, open a customer or supplier statement to see what is still owed, review cash and bank fund balances by currency, and review the stock list. See accounting, sales and purchases and reports. Next: the customer statement.

Scope of this article

This article explains general accounting principles using IFRS terms and an invented company. Tax and statutory rules differ by country and are not covered; check them with a qualified accountant.