A company can be profitable but yet, not have enough cash to carry out its expansion plans or pay its employees.
The difference between profits and cash flow can be stark. Profits on the income statement is an accounting concept while the cash flow reported on its cash flow statement is an operational aspect of doing business.
In essence, cash is the lifeblood of a business and is absolutely essential for it to survive. It is similar to oxygen for humans: without it, a person will die immediately. The same things happen when a business is starved of cash.
On paper, the business may show that it is generating lots of profits. But the same business may still have to rely on financing to plug cash flow gaps for it to continue operations.
Today, I would like to explore the key differences between profits and cash and point out the correct way of analyzing a business.
Profit Is A Form Of Accounting Recognition
Fear not, we will not be going into the technical details of accounting today.
Suffice to say, profitability is an accounting concept which recognizes the sale of goods or services rendered, minus the operating expenses related to the sales transaction and the cost of running the business. The crux of the issue here lies in the recognition of revenue: that is, revenue can be recognized when a product or service is delivered, even though cash for that sales transaction has not been collected yet.
Therefore, profit can show healthy figures even if cash is not collected, because customers may either not be able to pay, or choose to return the goods (and revenue will have to be reversed out as well).
Cold, Hard Cash Flow
A company’s income statement displays the revenue and expenses of a business, which net off to obtain profit. The cash flow statement, on the other hand, records the flow of cash in and out of the business and shows whether the business is generating enough cash for its daily operations and for other business purposes.
Obviously, cash flow is much more important to the investor than profits because cash is what sustains the business and allows the business to pay for expenses such as inventory and equipment.
Focus On The Cash
Instead of drilling into the income statement for profitability alone, investors should focus on the movement of cash and cash flow of a business. Profits can be adjusted through one-off items, and the forlorn investor who does not read into the details may be lulled into a false sense of security, especially by companies that report high levels of profit which are derived from accounting adjustments rather than the core operations.
The Foolish Bottom Line
The importance of cash and cash flow cannot be understated. With that in mind, investors should shift their focus from the income statement to the cash flow statement instead. By tracking the cash flows within a company, investors get a clearer idea of whether the business is doing well or not.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.