Key takeaways
- Profit measures performance on an accrual basis, while cash measures when money actually comes in and goes out. The two figures can differ widely even in a company where nothing is wrong.
- Most of the gap comes from five areas: receivables, inventory, payables, investment and principal repayment.
- In the example, the company earns a net profit of THB 8 million, but its cash falls by THB 20 million.
This year's sales are the best since the company opened. The accounts say there is a profit, yet at month-end the owner has to call the bank to draw on the credit line to pay salaries. Many people suspect that someone has made the money disappear, or that the accountant has got the statements wrong. Usually it is neither. The money is still in the business; it is just not in the form of cash.
Think of a restaurant that is packed every day. Customers pay by card and through food-delivery apps, so the money reaches the restaurant several days late, yet ingredients must be paid for in cash every morning. Rent and salaries fall due on fixed dates. The restaurant's income statement looks good from the day the food is served, but the bank account recognises money only when it actually arrives. Profit is therefore a score on paper, while cash is the oxygen the business breathes today.
Why profit is not the same as cash
The income statement uses the accrual basis. Revenue is recorded when goods or services are delivered, even if the customer has not yet paid, and cost is recorded when the goods are sold, even if they were bought several months earlier. This basis shows the period's performance correctly, but it does not say on which day the cash arrives. The items that pull the two figures apart are as follows.
| Item | Effect on profit | Effect on cash |
|---|---|---|
| Credit sale; receivables rise | Revenue is recognised immediately | No cash received yet |
| Buying extra inventory to hold | Not yet a cost | Paid out when the payable falls due |
| Trade payables rise | No direct effect | Payment is delayed, so cash improves temporarily |
| Depreciation | Reduces profit | No cash goes out in that period |
| Buying machinery or refurbishing a branch | Recognised gradually as depreciation | Cash goes out as the payments are actually made |
| Repaying principal | Not in the income statement | The full amount goes out in cash |
| Paying dividends | Not in the income statement | The full amount goes out in cash |
Note that principal is not an expense. A company whose profit only just covers interest may therefore have no cash left to repay principal, which is why bank lenders pay more attention to cash flow than to net profit.
Example: THB 8 million profit, but THB 20 million of cash gone
A hypothetical example: a trading company has revenue of THB 100 million, cost of sales of THB 70 million, selling and administrative expenses of THB 18 million and interest of THB 2 million. Profit before tax is THB 10 million; tax at 20% is THB 2 million, leaving a net profit of THB 8 million (assuming the tax is paid within the year).
| Item (THB million) | Amount |
|---|---|
| Net profit | 8 |
| Add: depreciation | 3 |
| Trade receivables up from 10 to 25 | (15) |
| Inventory up from 12 to 20 | (8) |
| Trade payables up from 8 to 11 | 3 |
| Cash from operations | (9) |
| Investment in assets | (6) |
| Repaying principal | (5) |
| Net change in cash | (20) |
| Cash at start of year | 24 |
| Cash at end of year | 4 |
The THB 8 million profit is a real figure, but a net THB 20 million of cash is tied up in additional receivables and inventory, after deducting the part that payables absorb. This is before a further THB 11 million of investment and principal repayment.
So the question to ask is not where the money went, but which item it now sits in and when that item will turn back into cash. THB 25 million of receivables collected within 45 days is very different from THB 25 million that has been outstanding for almost a year, even though the figure in the statements is the same.
Reading the warning signs from a single ratio
Cash conversion of profit = cash from operations ÷ net profit
If this ratio stays below 1 for several periods in a row, it means profit is not yet turning into cash. In the example it is -9 ÷ 8 = -1.13 times. A growing business can be negative temporarily, but the owner must be able to explain why, and in which period it will turn positive again.
Property development businesses often run the opposite way to this example: down payments come in first, but revenue and profit are recognised only on ownership transfer. Cash in the bank therefore does not mean there is a profit, and that cash may already be committed to construction and tax.
Next steps
- Ask the accountant to prepare a cash flow statement at least quarterly, and to explain the difference between profit and cash as a list of no more than five lines.
- Review the receivables ageing report every month, separate out the overdue accounts and assign a named person to follow up each one.
- Split cash into money that is genuinely available and money that is already committed, such as tax, customer deposits or balances in restricted accounts.
- Before paying a dividend or buying an asset, ask what the lowest cash balance over the next 13 weeks will be after the payment.
- Separate principal from expenses, and set a target for cash from operations that is enough to repay principal without borrowing new money to do so.
- Decide how many periods the cash conversion ratio may stay below the threshold before the credit and purchasing policies must be reviewed.