What are the five major factors that make Profit and Cash different from each other?
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Transcript of What are the five major factors that make Profit and Cash different from each other?
What are the five major factors that make Profit and Cash different from each other?
Profit vs. Cash / #1 SALES
• The sales income (or revenue) is realized, when you send the invoice -> is shown in your Income Statement immediately
• However, you receive the payment only after the term of payment -> affects the cash later
• Sales that you have not yet received to your cash can be found: Internal – Accounts receivable
Profit vs. Cash / #2 EXPENCES
• Costs are expenses that belong to the same year: raw materials, labour expenses, energy,…
• For example, raw materials costs are are realized immediately when you order raw materials – affects the Income statement immediately
• The money leaves your cash only after the payment time: Accounts receivable
• There are also payments that are expences for the future years…
Profit vs. Cash / #3 INVENTORY
• Purchases of materials in the period are all treated initially as expenses
• However, the materials are not all used up in the accounting period => necessary to make an adjustment that reduces the expense for stock on hand
• An example: two identical companies A and B with the only difference that A has bought raw materials worth of 200.000 and B worth of 300.000
• Should the result of B be 100.000 worse, although it has not used the extra raw materials worth of 100.000?
Profit vs. Cash / #3 INVENTORY
• The income statement is balanced with an item called Change in inventories (the example assumes that the inventory has been 100.000 in the beginning of the year):
A B
Turnover 1.000.000
1.000.000
Raw material purchases
200.000 300.000
Change in inventories 0 + 100.000
Other costs 700.000 700.000
Profit 100.000 100.000
Profit vs. Cash / #3 INVENTORY
In your Cash the raw materials are always paid after the term of payment
In the Income statement all the raw materials are not necessarily marked as costs
Profit vs. Cash / #4 LOANS
• Having a bank loan is not income from running the business. Paying the loan back to the bank is not a cost of running your business => loans are not shown in your Income statement, but in your Balance sheet
• However, the interest from the loans is treated as a cost (shown in the Income statement)
Thus, loans are shown only in your Cash, not in your Income statement
Profit vs. Cash / #5 INVESTMENTS
• Long-term investments affect during several years – they are expenses of future years
• This is the case when we buy fixed assets: the asset is not used up in the year of purchase, and so it would be unfair to treat the whole payment as an expense of that year
• If the machine will last for ten years, the cost is spread over ten years rather than charged totally to the year of purchase or not charged at all. It is reasonable to allocate the cost of the expense over the life of the asset.
• Called a depreciation expense
Profit vs. Cash / #5 INVESTMENTS
Profit vs. Cash / #5 INVESTMENTS
Profit vs. Cash
• The previous five reasons explain why cash (cash flow) does not reveal the profitability of the business
• A company with profitability problems may have a good cash situation, e.g., because of loan taking
• The bad cash situation of a profitable business may stem from long terms of payments in sales
• In any case, the adequavy of cash is a prerequisite for successful business management