Cash Vs Profit - are they the same? Which is more important?
Profit is considered one of the most important figures in a company’s financial statement. While this is true, profit is not the only important figure. Cash is equally as important. Most often cash and profit are used terms that are used interchangeably. However, understanding the difference between the two terms is necessary to run a business successfully.
What is profit?
Profit is the excess of revenue over expenses. Yes, it is as simple as that. Profit is generally calculated in one of the financial statements called “Profit and Loss statement”. It is mandatory by law that a company prepares a P&L statement.
What is cash?
Cash is the amount of money that has actually went in and out of the company over a period of time. A cash flow statement has three main classifications being:
Cash from operating activities
Cash from investing activities
Cash from financing activities
Now, these two seem very similar from what you have read so far. So let us break down the reasons causing differences to make it easier to understand. Let us classify those differences into 3 broad categories: Accruals concept, Non-cash items and Balance sheet items.
The question of what is important to a business- cash or profit- bugs us always!
Accurals concept
The concept of “accrual accounting” is the most common method of preparing financial statements. The accrual concept is the most important accounting concept which requires revenue to be recorded when it is “earned” and expenses to be recorded when they are “incurred”. Note carefully that the terms “earned” and “incurred” are used instead of “received” and “paid”. For example, you have purchased a laptop in the month of January 2020 but pay for it March 2020. Under the accrual concept, the laptop will be accounted for in January 2020 even though the payment was made much later. This difference in timing is one the first reason that cash and profit are not the same.
Non-cash items
The profit and loss statement includes many “non-cash items” such as bad debts and provisions. Non-cash items are basically items that do not involve any real inflow or outflow of cash but is a mere accounting adjustment. To elaborate, bad debt is the amount of sales that we have failed to collect. In this case, no money actually leaves this business but is recorded as an expense.
Balance sheet items
As mentioned above, a cash flow statement contains three elements: cash from operating activities, investing activities and financing activities. The operating activities in the cash flow statement cover the expenses that appear on the profit and loss (although there might be a difference in the periods they appear). However, cash from investing and financing activities usually appear on the Balance sheet of a company rather than the profit and loss statement. For example, you buy a machine for your business. This is an asset and will be recorded in your balance sheet but it will also be considered a cash outflow and appear in the cash flow statement.
Which is more important?
As mentioned in the beginning, cash and profit are equally important. There has always been a “trade-off” between the two. Having too much cash or too less cash can both be harmful for a business. Maintaining too much cash is called the “conservative” approach of management and maintaining too less is called the “aggressive” approach to management. While having too much cash in hand, you will definitely be able to run your business smoothly but also might miss out on good investment opportunities by being too conservative. On the other hand, by maintaining very little cash you might end up not being able to pay off your creditors. This will damage the relationship with the supplier and might result in cutting off supplies disrupting the entire business.
Thus, a balance has to be maintained between liquidity (cash and assets that are easily convertible into cash) and profitability. Every company will have its unique optimum balance and figuring it out is the key to run a successful business!
Do you need help in managing your cash flows? Reach out to Accountifi and we will have a team of professional accountants ready to cater your needs.