Profit Is Not Cash

The distinction

Profit is calculated on the accruals basis: income recognised when earned, costs when incurred. Cash is what is actually in the bank. A business fails when it runs out of cash, not when it reports a loss — and businesses fail while reporting profits with some regularity.

What separates them

• Receivables — a sale is profit immediately and cash only when paid.
• Inventory — cash paid out now, charged to profit only when sold.
• Payables — a cost charged now, cash out later.
• Capital expenditure — cash out now, charged to profit over years as depreciation.
• Depreciation and amortisation — a charge against profit with no cash movement at all.
• Loan repayments — capital repayment is cash out with no effect on profit; only the interest is a cost.
• Tax and dividends — paid on their own timetable.
• Provisions — charged against profit before the cash is spent.

Why growth consumes cash

Consider a business that grows sales by fifty per cent. It must buy more inventory and fund more receivables immediately, while the cash from the additional sales arrives sixty days later. The profit is real, and the cash requirement precedes it. This is overtrading: expanding faster than the available funding supports, and it is one of the most common causes of failure among successful businesses. The remedies are to slow growth, improve the cash conversion cycle, or secure funding before the growth rather than during it.

Reading the cash flow statement

• Operating cash flow should track operating profit reasonably closely over time. Persistent divergence is the single most useful warning signal in a set of accounts.
• Free cash flow — operating cash flow less capital expenditure — is what is genuinely available for debt repayment, dividends and investment.
• Look at the movements in working capital within operating cash flow. A large outflow explained by inventory or receivables growth deserves a specific explanation.

Measures of liquidity

• Current ratio — current assets to current liabilities.
• Quick ratio — excluding inventory, which may not convert quickly.
• Cash burn and runway — net cash consumed per month, and how many months of cash remain at that rate. The essential measures for a loss-making or early-stage business.
• Facility headroom — undrawn committed facilities plus cash, which is the number that actually determines whether you can pay next week.

Balance sheet ratios describe one day. A business can arrange a healthy year-end position and be under severe strain in the months either side, so ratios should always be read alongside the cash profile through the period.