Understanding Why Profit Doesn’t Equal Cash

“I’m making a profit but I have no cash!”

As a business owner, a lot of emphasis is placed on your Profit & Loss (P&L) Statement. It provides a snapshot of your business’ performance, showing whether you are making a profit from your day-to-day business trading.

BUT…. The profit showing on your P&L does not equal the cash in your bank account! And it is super important to be able to distinguish the difference between profit and cash!

This difference can be confusing, especially when your business appears to be profitable, yet you’re still struggling with cash flow. Understanding these differences is essential in making better financial decisions for your business.

What Is a Profit and Loss (P&L) Statement?

I’m sure you have read my blog “Why you need to use your Profit & Loss”, but as quick refresher- a P&L statement is a financial report that summarises the income and expenses incurred during a specific period—usually a month, quarter or year. This report helps business owners assess their financial performance and profitability.

The basic equation for a P&L statement is: Income - Expenses = Profit (or Loss)

Cash Flow vs. Profit

Now, following on from the profit of your business, we can compare the two-

• Profit is what remains after all your expenses have been deducted from your revenue. This reflects the financial success (or failure) of your business over a period.

• Cash Flow refers to the actual movement of money in and out of your business. It tracks the liquidity of your business- how much cash is available to pay bills, pay yourself or invest in business assets & growth.

Reasons Why Profit Does Not Equal Cash

Here are some of the most common reasons your P&L profit might not match your actual cash flow:

1.     Loan Movements

When a business draws down on a loan, the loan proceeds are considered a cash inflow but are not reflected in your P&L as income. You do not pay income tax or GST on these funds. Conversely, the loan repayment outlay is also not fully captured in your P&L.  

The principal portion of the loan repayment doesn’t affect your profit since it's considered a liability repayment, but the interest portion will appear as an expense on the P&L.

• Example: If you take out a loan for $50,000, you’ll have a cash inflow into your bank account, but this is not profit or taxable income. Additionally, the repayment of the principal amount each month won’t show up on your P&L; only the interest portion does.

2.     Owner’s wage

How do you pay yourself? Depending on your business set up, you may be classified as an “employee” & paid through the proper payroll procedures. Or you may take an owner’s profit share (wage/drawing/dividend payment, whatever you call it). The difference to you? Not much, really.

But when calculating profit, only an “employee wage” will be recorded as a deduction through the P&L. Any “after profit” owner’s drawing is not reflected in your P&L. Rather; these transactions are recognised as a balance sheet movement.

When assessing the profitability of your business, the return (cash) you are getting from your hard work needs to be factored in.  

• Example: As the business owner, you withdraw extra funds for a personal family holiday. This is not reflected as a deduction in the P & L, but is a cash outflow.

3.     Plant & Equipment purchases

When purchasing large plant and equipment items required to run your business, these items are recognised as an asset and are recorded on the balance sheet. The idea behind this is that these assets are used in your business over many years, as opposed to a day-to-day trading expense. The cost of the assets are not fully recognised in the P&L but paying for the asset immediately depletes the cash in your bank account.

• Example: If you purchase a new car, it will reduce your cash flow. However, the payment will not be a deduction in your profit and loss.

4.     Changes in Working Capital

Your working capital, which includes items like accounts receivable, accounts payable, and stock, can impact cash flow without affecting profit. If your accounts receivable increases, you might show higher sales and profit, but if you haven't collected that money yet, your cash flow is lower. Similarly, increasing stock purchases or paying off outstanding bills can reduce your available cash, even though your P&L remains unaffected.

• Example: Your business carries a large amount of stock, which is a cash outlay when purchased. However, the cost of the stock is only deducted through the P & L once it has been sold (it will sit on the balance sheet as an asset until then).

5.     Non-Cash Expenses

Certain expenses on your P&L do not involve an immediate outflow of cash.  The most common example is depreciation. Depreciation represents the decrease of value of plant & equipment assets over their effective life. While depreciation lowers your profit over a period, no actual cash is spent after the initial outflow.

• Example: You purchase a machine for $10,000. You’ll depreciate it over several years on your P&L, but in the years following purchase, there is no actual cash outlay.

6.     Accrual Accounting

Most businesses use accrual accounting, which means that income and expenses are recognised on invoice date, not when the cash changes hands. For example, if you issue an invoice to a customer, the sale is recorded as revenue on your P&L, even if the customer hasn’t paid you yet.

• Example: If you made a sale in April but haven’t received payment until May, your April P&L will show revenue from that sale, even though your cash flow won’t reflect that payment until the following month.

Why do you need to know this?

At the end of the day, having money is the most important thing- “Cash is king” as they say.

Understanding the connection/disconnection between your business profit and cash flow is crucial for effective business management. Here’s why:

• Cash is King: Even if your business is profitable on paper, a lack of cash can lead to problems such as an inability to pay employees or suppliers. Cash flow ensures that you can cover daily operations, meet obligations and plan for future business goals.

• Managing Growth: If you're planning to expand, you may need to invest in new equipment, hire more staff, or launch new marketing campaigns. Profit on your P&L may not provide the immediate liquidity required to fund these activities if your cash flow is restricted.

• Financial Health: By keeping track of both profit and cash flow, you can ensure that your business foundation is solid. Having this data available in real time, you can make any changes or adjustments to improve cash flow and maintain profitability.

While profit and cash are both essential measures of your business’s financial health, it’s important to understand the differences between the two.

While the P & L statement shows your business’s profitability, it’s also essential to also regularly review your cash flow statement to ensure that your business has the liquidity needed to operate and grow.

Profits are important, but cash is what keeps your business running!

Disclaimer: The circumstances of each business are different. This document is not financial advice and does not take your personal circumstances into account. Use this guide but consult your accountant or financial adviser for information specific to your circumstances.