Profit vs Cash Flow
A business can report healthy profits and still collapse. This happens because profit and cash flow measure different things, and the two can move in opposite directions at the same time.
The financial gain that results when total revenue exceeds total costs over a given period. It can be expressed as gross profit, operating profit, or net profit.
The movement of money into and out of a business over a specific period, covering all cash receipts (inflows) and all cash payments (outflows).
Three structural features of business cause the gap between profit and cash:
- Credit sales. When a business sells on credit, revenue is recorded immediately but cash may not arrive for 30, 60, or even 90 days. During that gap, wages, rent, and supplier bills still fall due.
- Inventory holdings. A jeweller or car dealer with large stock has real value on the balance sheet, but that value cannot pay a wage bill until the stock is actually sold.
- Capital investment. Buying machinery or property triggers a large cash outflow upfront. The asset will generate revenue over years, but the cash leaves on day one.
A construction firm purchases a large piece of plant equipment, draining its cash reserves.
It has won profitable contracts and expects strong revenues, but right now it cannot cover the wages due at the end of the week. The firm is profitable and illiquid at the same time.
The three key differences to hold in mind:
| Dimension | Profit | Cash Flow |
|---|---|---|
| Timing | Recorded when a sale is made, regardless of payment | Recorded when cash physically moves |
| Scope | Overall financial performance | Liquidity and short-term survival |
| Purpose | Signals long-term viability | Determines whether bills can be paid today |
A common mistake is to assume a profitable business is automatically safe. Profit is an accounting measure; cash is what pays suppliers and staff. Many business failures occur in growing firms where sales outpace cash collection.
Working Capital
Day-to-day operations require a steady supply of funds that are separate from long-term investment. Working capital is what provides that supply.
The difference between a business's current assets and its current liabilities. It represents the net short-term resources available to fund daily operations.
Current assets are resources convertible to cash within one year: cash itself, trade receivables (amounts owed by customers), and inventory.
Current liabilities are obligations due within one year: trade payables (amounts owed to suppliers), short-term loans, and accrued expenses.
A small retailer holds current assets of 10,000, receivables 20,000) and current liabilities of 15,000, short-term loan 5,000).
The business has $20,000 available to fund operations and absorb short-term shocks.
Four reasons working capital matters in practice:
- Smooth operations. Staff get paid, stock gets ordered, and utilities stay on because the funds are there.
- Liquidity management. A business can be profitable on paper but unable to settle a supplier invoice. Adequate working capital prevents that disconnect from becoming a crisis.
- Financial buffer. Positive working capital gives managers room to absorb an unexpected cost or move quickly on a discounted bulk-purchase opportunity.
- Creditworthiness. Banks and suppliers examine working capital when deciding whether to extend credit or favourable payment terms.
An assessment of an entity's ability to repay its debts, based on factors including income stability, existing debt levels, payment history, and cash flow reliability.