Cash Flow vs. Profit: Why Profit Is an Opinion and Cash Is a Fact
Tim Hinkel, Ph.D., CPA, CMA, CSCA, is the Chair of the Department of Accounting and Management Information Systems and an associate professor of accounting at Ashland University. He teaches both undergraduate and graduate courses in accounting.
Why Profit and Cash Are Not the Same
One of the most common misconceptions in business is that profit and cash are basically the same thing. They are not. A company can report profit and still struggle to pay employees, suppliers, lenders and other obligations. In fact, a growing company can sometimes become more profitable while simultaneously creating a serious cash-flow problem. That is why the statement, "Profit is an opinion. Cash is a fact," is a useful way to think about financial performance.
How Accrual Accounting Separates Profit From Cash
First off, profit is not fake, and accountants do not simply get to choose whatever profit numbers they want. Financial (accrual) accounting standards provide rules for determining when revenues and expenses should be recognized. But calculating profit still requires judgment. Accountants make estimates about uncollectible accounts receivable, depreciation, inventory values, warranty obligations, useful lives of assets and many other items. Those judgments affect the amount of reported business profit.
Cash is different. At some point, the money either entered the bank account or it did not. Consider a simple example. Suppose a business completes a $100,000 sale to a customer in December, ships the item and sends the customer an invoice. Under accrual accounting, the company would likely recognize the $100,000 of revenue in December because it has completed its performance obligation and earned the revenue. But what if the customer does not actually pay until February? The company has revenue. It may have profit. But it does not yet have the cash. The opposite can happen with expenses. Suppose a company purchases a $200,000 piece of equipment with cash. Its bank balance decreases by $200,000, but under accrual accounting the entire $200,000 usually does not become an expense immediately. Instead, the cost of the equipment is generally allocated over its useful life through depreciation. Once again, the movement in cash and the effect on accounting profit are dramatically different.
Why Growth Consumes Cash
Growth often consumes cash, which escalates the difference between profit and cash. We naturally associate growth with success. Sales increase. Customers increase. Maybe profits increase as well. But growth often requires cash before it produces cash. A growing business may need to purchase additional inventory, hire employees, expand its facilities, acquire equipment or invest in marketing. It may also allow customers to purchase on credit, meaning sales are recorded before the cash is collected.
Consider this example. A company reports $250,000 of profit for the year. That sounds like a very successful year. But during that same period, accounts receivable increased by $150,000 because customers have not yet paid. Inventory increased by $75,000 in anticipation of future sales. And the company spent another $100,000 on equipment. Suddenly, that $250,000 of accounting profit does not translate to $250,000 of additional cash in the bank.
Why Small Businesses Should Put Cash First
For a small business, cash should come first. Large public companies have extensive financial-reporting obligations and prepare financial statements using accrual accounting principles following U.S. GAAP. The typical small privately owned business operates in a very different environment. Most small businesses are not required to produce GAAP financial statements for outside investors. Their owners are often much more concerned with a different set of questions:
- Can I make payroll next week?
- Do I have enough money to pay my suppliers?
- Can I make the loan payment?
- Can I afford another employee?
For those decisions, cash management is critical. Therefore, for many small businesses, an owner's primary financial focus should be cash generation and cash management rather than financial accounting profit.
A business owner who knows exactly how much cash is coming in, how much is going out, when major obligations are due and how much liquidity the company needs has information that is immediately useful. What financial information actually helps the owner make better decisions? For most small businesses, the answer starts with cash, but cash does not tell the whole story.
When Accrual Accounting Adds Value
As a business becomes larger or more complicated, accrual-based information can become incrementally valuable even when the owner is primarily focused on cash. Accrual accounting helps smooth out the natural ‘lumpiness’ of cash-based results so managers can better assess a business’s underlying profitability. Cash receipts and payments often occur at uneven times. A customer may pay weeks after a sale, an annual insurance premium may be paid all at once, or a large equipment purchase may create a major cash outflow in a single month. Accrual accounting instead recognizes revenues when they are earned and matches expenses when they help generate those revenues. By matching economic activity to the period in which it actually occurs, accrual accounting produces a more stable and meaningful picture of operating performance, making it easier to determine whether the business itself is truly profitable rather than simply experiencing favorable or unfavorable cash timing.
Cash vs. Accrual: Two Different Questions
Cash answers one set of questions. Accrual accounting answers another. This is why I don’t frame cash and accrual accounting as competitors. They answer different questions. Cash accounting asks: Where is my money? Accrual accounting asks: How is my business actually performing economically? For a small-business owner, the first question deserves priority. Without sufficient cash, nothing else matters. Employees still have to be paid. Vendors still expect payment. Banks still expect loan payments. But once a business has good control over its cash, accrual information becomes an incredibly useful additional layer. It can tell an owner whether current sales are truly profitable, whether expenses are being matched with the revenue they generate and whether margins are improving or deteriorating. That information becomes increasingly important as a company grows and the timing between economic activity and cash movement becomes more complicated.
The Bottom Line
Profit requires judgment. Cash requires counting. For many small businesses, counting the cash should come first. But as the organization grows, understanding the economic story behind that cash becomes increasingly important. A profitable company can run out of cash. A company with plenty of cash today can still have an unprofitable business model. The best managers understand both. And that is why good financial management starts with cash, but it should not end there.