Why Unprofitable Companies Can Still Generate Cash?

It may seem counter-intuitive to think that there are unprofitable companies that still consistently generate cash. How is that possible? The broad answer is that accounting standards can cause some of these discrepancies. Some items are marked as an expense in the income statement but do not affect a company’s cash flow.

With that, let’s take a look at some of these accounting standards that can cause the discrepancy.

Share-based compensation

Many fast-growing companies reward high-level management with share-based compensation on top of their regular salary. This gives managers the incentive to help the business grow as they now have a stake in the company too. Furthermore, share-based compensation does not affect the company’s cash flow.

By standard accounting standards, share-based compensation is marked as an expense on the income statement. Using this accounting method, this type of cost eats into profits but does not affect cash flows.

Depreciation and amortisation

Depreciation is an accounting term used to allocate the cost of an asset over its useful life. For instance, a computer with an operating life of ten years and purchase cost of $1,000 will be depreciated at $100 per year. This is recorded as a depreciation expense in the income statement. Although they are recorded as expenses, depreciation and amortisation do not have any effect on cash flows.

This affects many technology companies that have large depreciation costs related to their infrastructure and software. This can eat into profit margins, and due to this, many technology companies end up reporting losses but are still cash flow positive.

Accrual accounting methods may lead to discrepancies between cash received and recognition of revenue

Under the accrual accounting system, revenue is reported on the income statement only when they are earned and not when the cash actually comes in.

For example, an oilrig building company secures a contract of $10 million to build an offshore oil rig at the end of 2018. It receives 30% of the contract amount at the date of signing in 2017. Although it has received cash for the work, it may not be able to count it as revenue until the job has been completed. The company will, therefore, report cash earned on its cash flow statements but will not be able to report the revenue and profits for the job until it has been completed.

The Foolish takeaway

These three aspects can sometimes cause discrepancies between cash flow and income. Investors should look out for companies that can generate both profits and cash at the same time. Companies that generate profits but constantly have negative cash flow may run into near-term liquidity issues. At the same time, what good is a company for shareholders if it can generate cash but is unable to constantly make profits in the long-term?

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.