statement of cash flows

Let us today revisit the issue of cash in the business. Of course cash is a very important factor in business and also in personal and family life. If you don’t agree with me here then possibly you might be from another planet and not earth. I’m currently speaking from the perspective of the earth only. It is usually said that cash speaks the language that everybody understands. I have previously posted some articles on cash in this blog, and you might give yourself a gift by reading those articles. These include Why An Entrepreneur Must Understand His or Her Cash Flow, and Part 2 of that same article, together with Why Cash Flow Problems May Persist In An Enterprise.

Sometimes an entrepreneur might not decode why he has made so much profit in a given period and yet there is no money in the bank to reflect this. To entrepreneurs who can interpret financial statements this might be a no-brainer, but unfortunately not all entrepreneurs fully understand and can analyze financial statements. Now, it is neither a sin nor a crime for an entrepreneur not to understand every detail of a financial statement, though this leaves some gaps in decision making for the enterprise. Many enterprises have accountants (bean counters) anyway, so an entrepreneur who cannot fully understand financial information can simply consult his accountant. Let’s assume the accountant is able. Are we together so far?

So, in my blog today I intend to briefly explain why profit does not equate to cash. I mean, why an enterprise might make so much profit but close the year with hardly any cash in the coffers. These are also the reasons why a company might make huge losses and still have cash in its coffers after all. We are talking about reasons why accounting profit does not equate to cash and cash equivalents in the business (whether in the premise or in the bank). I know some entrepreneurs don’t like keeping their monies in the bank, for whatever reasons. They like to see money near them in the house or in the business premise! I will spare you for today if you are such an entrepreneur, but you might not escape my rebukes next time! Ok?

This topic is not a difficult one, and under normal circumstances every entrepreneur should understand this. Don’t you agree with me? By the way, in most financial statements, there is a page or section called statement of cash flow or cash flow statement that provides this reconciliation. It starts with your book profit and ends with your cash and cash equivalents at the close of the period. The problem is that many people do not bother to study this section of the report. Additionally, some accountants simply cannot explain this fact, leave aside doing the reconciliation. Now, when the tzars of numbers fail then you can only imagine what happens to the rest. Can’t you? I insist – it’s not a difficult one and in this write up I will try and keep it simple for everybody to understand. Let’s go now.

  1. Non-cash expenses such as depreciation and amortization of intangible assets. One of the very basic reasons why your profit does not automatically mean cash in the bank, is the aspect of depreciation, or wear and tear of fixed assets you have in your books. These assets can be physical/tangible or intangible. This wear and tear is just a number calculated based on some parameters such as the useful life of the asset etc. The simple idea is to write off the value of the assets eventually to nil or some minimal residual value at the time the asset has outlived its usefulness. While this is deducted at arriving at the net profit, it does not involve outflow of cash, hence it becomes a reconciling item. Depreciation and amortization has to be added back to your net profit to bring you closer to your cash position – but it’s not the only item. We are going to consider other items below. I hope you are still flowing with me!
  1. Changes or movements in your working capital items such as stocks, debtors and prepayments, current liabilities or payables etc. Your working capital items are another set of reconciling items that make your net profit differ from your cash at bank at any one time. We know that working capital is total current assets (stocks/inventories, debtors, prepayments and other receivables, cash etc.), less total current liabilities or all payables due within the period of a year. If you have never known working capital then today is your day. Otherwise, back to our cash flow business, changes or movements in these components of the balance sheet or statement of financial position are reconciling items that partly explain why our net profits do not necessarily equate to our cash balance. Don’t you agree with me? Let me elaborate on this. You could have used a portion of your net profit to buy more stocks, hence this increase in stocks or rather profit invested in stocks have to be reduced from your profit to get you closer to your cash balance. The same applies if you sold on credit and increased your trade receivables or you made prepayments for one reason or the other, all these increases have to be deducted from your profit to arrive at your cash balance.  However if your stocks, debtors and receivables decreased then it means your cash position is improving or increasing, hence the need to add back to profit. When you make sales stock reduces and when you collect debt, receivables reduce while cash increases. For liabilities or payables however the effect is a reverse one. When you settle liabilities and other payables you are using cash. Cash reduces and this means that you have to reduce your net profit to come to your cash position. When payables increase however, you have to add back that increase to your profit to arrive at your cash position. Do you understand me? I’m trying to use illustration to drive down my points.
  1. Interests and taxes paid. Interest and tax is another reason why your net profit will not equate to your cash balance. When you have borrowed money on which your enterprise is paying interest, then this interest becomes another reconciling item between your net profit and your cash balance. When you pay interest you use money hence you have to reduce your net profit to arrive at your cash position. Don’t you think so Mr. Entrepreneur? Come on, this is simple reasoning. The same is true when you pay tax. You spend your hard-earned cash to do this and it implies that you have to reduce your net profit with that amount to arrive at your cash balance. You have used part of your profit to pay interest and tax. If however, you accrue more interest and tax without paying then these will have to be added back to your net profit to arrive at your cash position. Now, again some people dislike tax like a plague. I encourage you to pay tax – but not too much. Do you get me? Let’s assume that the tax collectors are not reading this. Ok?
  1. Investing activities such as purchase or sale of fixed assets, capital work-in-progress. My dear entrepreneur, when your business buys assets such as vehicles, computers, machinery, furniture etc. you are spending cash. This cash could be part of your profit and this is why you need to deduct it from your profit to arrive at your cash balance. This is the same when you invest in capital work-in-progress. So, what happens when you sell or dispose of such assets or capital work-in-progress? I believe you know the answer already. These add cash to your coffers hence you need to add these to your net profit. This thing is getting pretty simple – in fact too simple. Isn’t it Mr. Entrepreneur?
  1. Financing activities such as capital inflows or outflows, bank loans, directors’ loans etc. Another major reason why your net profit will differ with your cash balance is financing the business. Some entrepreneurs have big appetite for borrowing. They will continue borrowing until they can manage it no more and this sometimes knocks them out of business. Anyway, our focus is not on the dangers of excessive borrowing today. Our focus is simply to explain reconciling items that make net profit not translate into cash at the bank. When you bring in money to the business, whether as capital, bank loans, grants or shareholders’ loans, your cash position improves and this means that you have to add these to your net profit to arrive at your cash position. In other words, these inflows of cash into your enterprise improve your cash balances beyond the cash arising from purely profit that you have made. The reverse is true. When you pay back loans you reduce your profit to get you closer to your cash at hand position.
  1. Other exceptional factors such as prior year adjustments etc. Now, beyond the above major areas there are occasionally unique reconciling items. These also help in explaining why your business net profit differs from your cash balance. The most common I can mention here is prior year adjustments. Causes of prior year adjustments are many, but it principally means that something was not stated correctly in the financials of the previous year hence the need to correct it. This could have a positive or negative effect on your cash flow, so you might need to add or subtract it from your net profit to arrive at your cash balance.

So, my dear entrepreneur, I believe you now have some good clues as to why sometimes your cash balance is very far away from your reported profit as per your financial statements or books of accounts. You don’t need to be worried and clueless – always relying on your accountant who might even give you wrong information and explanations regarding some business situations. Having someone who has an accountant’s qualifications is very different from having an accountant. Do you get what I mean? Not every accountant is worth the name, so sometimes you have to find your own way of understanding your business to avoid being taken for a ride. The above factors explain the variance between net profit and cash balances hence should put your mind to rest because sometimes the two are very far apart like Tokyo is to New York.

The above factors also explain why you can be making serious losses but your cash balances are positive and you are staying afloat. Without these reconciling items, one would assume that your losses should translate into bank overdrafts or loans etc. Situations where net profit equals to cash balances are very rare and unique. An example is where you purely use cash accounting instead of accrual accounting. In this case you can mechanically trace every kobo or coin into your profit and loss account and subsequently into your cash and bank balances. Your cash balances, among other factors, by the way determine your ability to settle bills as they fall due.  Mess with your cash flow management at your own risk! Ok? At least my hands are clean, because I’m giving you valuable and free advice.

I guess I need to end it here for today.

With every good wish – and till then,

The Wise Entrepreneur


January 28, 2018

Reasons Why Profit Does Not Equate To Cash In The Bank

Let us today revisit the issue of cash in the business. Of course cash is a very important factor in business and also in personal and […]