Cash Flow For Dummies
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Profit doesn't equal cash flow in a business. To find out if you made a profit or had a loss for the year, you look at the bottom line in your P&L (profit and loss) report. But you must understand that the bottom line does not tell you cash flow from your profit-making activities.

Don’t ever assume that making profit increases cash the same amount. A business’s cash flow can be considerably higher than bottom-line profit, or considerably lower. Cash flow can be negative when you earn a profit, and cash flow can be positive when you have a loss. There’s no natural correlation between profit and cash flow.

The image below illustrates the differences between sales revenue and expenses (the accounting numbers used to measure profit) and the cash flows of the sales and expenses. Only three expenses are shown: cost of goods sold, depreciation, and one total amount for all other expenses. (Note: Reporting expenses this way is not adequate for managers in a P&L report and is not acceptable for income statements in an external financial report.)

Comparing sales and expenses and their cash flows.
Comparing sales and expenses and their cash flows.

Here are the reasons for the cash flow differences in the figure:

  • Your accounts receivable (from credit sales) increased $100,000 during the year, so actual cash collections from customers were only $4.9 million during the year — a cash flow shortfall of $100,000.

  • You built up your inventory $225,000 during the year, so your cash outlays for products were $225,000 higher than the cost of goods sold expense for the year.

  • Depreciation expense is not a cash outlay in the period recorded; the cash outlay took place when the fixed assets being depreciated were acquired some years ago.

  • Total cash outlays for other expenses were $165,000 lower than the amount of expenses recorded in the year, mainly because your accounts payable and accrued expenses payable liabilities increased during the year — you had not paid this amount of expenses by year-end.

Every situation is different, of course. Cash flow isn’t always lower than profit for the year. Suppose accounts receivable had remained flat during the year; your cash flow would have been $100,000 higher. If you had not built up your inventory, then . . . you get the picture. You must keep close tabs on the changes in the assets and liabilities that impact cash flow from profit.

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