Cash and profit are equally important to a business organization. However, businesses often fail because their owners do not understand the difference between cash and profit. Even though many new businesses make a profit, they do not survive very long because they do not manage their cash well.
Cash ≠ Profit. What’s the difference?
Profit is not the same as cash. And cash is not the same as profit.
While some companies can be cash-rich while not making any profit, some other businesses can be very profitable, but run out of cash. Therefore, it is crucial for entrepreneurs and business managers to understand that cash and profit do not have the same meaning. Nor they have the same significance in a business organization.
Let’s take a look at the very basic differences between cash and profit.
Cash
Cash is business finance. And finance means money. And money for a business is cash. Cash is called the ‘lifeblood’ of a business because every business organization needs cash to cover start-up costs, keep functioning and expand. It is simple. Cash is the money that a business actually receives from the sale of goods and provision of services. It can exist in the form of cash in hand (cash in the business kept in the safe, locker, drawer, etc.), or cash at bank (cash in the corporate bank account). Cash belongs to Current Assets in Balance Sheet.
A business uses Cash Flow (Cash Flow Statement and Cash Flow Forecast) to effectively manage all of its cash transactions.
Profit
Profit is the positive difference between the firm’s total Sales Revenue and Total Costs (TC) of production. Loss is the negative difference. Let’s take a look how profit is calculated using the formula for profit:
Profit = Sales Revenue – Total Costs (TC)
Or, to be more specific:
Profit = Price x Quantity – (Fixed Costs (FC) + Variable Costs (VC))
When a sale is made to the customer, each sale contributes towards paying the firm’s Total Costs (TC). When enough products are sold to pay for all of the business costs, then the firm breaks even. All sales beyond a firm’s break-even point generate profit for the business. So, profit is made after all production costs, and the costs of running the business, are paid for. And, after the customer buys the product, and the payment is made, then the business receives its cash.
A business uses Profit and Loss Account (P&L Account) to effectively manage its sales revenue, all costs and profit.
Profitability (profit) vs. Liquidity (cash)
Profitability and liquidity are essential for the long-term survival of any business, large or small. It is important to have enough cash in the short term and be profitable in the long-term. Cash payments must always be made, but profit can wait to be earned later.
1. Profitable and liquid
It is possible for a firm to be profitable and be cash-rich. This is an ideal scenario when a profitable business has cash surplus.
- Sell products profitably for cash only. Let’s say there is an entrepreneur who buys inventory from suppliers every month worth USD$1,000. He pays cash only to the traders. An entrepreneur is able to get himself a very good deal because of using cash to pay for those supplies. The suppliers are willing to offer him attractive price. Then, the entrepreneur sells all of its stock to customers who also pay using cash. Let’s say in a typical month, the entrepreneur can sell all his products and generate sales revenue of USD$2,000. As he does not incur any other costs, he is able to make profit of USD$1,000 every month. Because all of his purchases of supplies and sales were in cash, Net Cash Flow (the difference between Cash Inflows and Cash Outflows) is USD$1,000 every month which equals net profit. This business is both profitable and liquid. Excellent job!
2. Profitable but not liquid
It is possible for a firm to be profitable but cash deficient. A profitable business may run out of cash.
- Trade credit is too long. A business sells its products giving trade credit to customers. Therefore, a profit is being made as the goods are being recorded in Profit and Loss Account (P&L Account) the moment they are sold. This increases profit, but it does not increase any cash until the buyer finally pays for the goods. When the cash payments from customers are received too far in the future, the long period of trade credit leaves the firm dangerously short of cash. This poor credit control will damage the firm’s cash flow position. Firms with huge Cash Outflows will be very short of cash until they receive payments from customers. There is a real danger that the firm may run out of cash to pay its everyday costs, such as wages and rent.
- Expanding too quickly. When a business tries to expand too quickly, it is spending too much cash on purchasing Fixed Assets such as premises (land and buildings), equipment (machinery) and vehicles. These Fixed Assets are very expensive and may cause the firm to run out of cash. Any capital expenditure on Fixed Assets decreases the cash balance in the short-term, but have no effect on the profit that a company makes. This is because the purchase of an asset is not treated as an expense in Profit and Loss Account (P&L Account), only the depreciation of that asset becomes the cost.
- Unexpectedly high demand during high season. Seasonal variations in demand can also mean that there are certain times in the year when the firm might experience short-term liquidity problems. It is when the demand for products increases rapidly during high season. The business needs to purchase lots of raw materials and hire additional part-time workers. This all requires much more cash to be injected into the business within a very short-period of time. Ultimately, a business cannot operate without sufficient cash as it has to pay its suppliers, employees and lenders. A lack of cash to pay bills may eventually lead to a firm going bankrupt.
3. Not profitable but liquid
It is possible to be for a firm to be cash-rich but unprofitable. A business recording a loss may have cash surplus.
- Cash received for last year’s sales. A business receives cash at the beginning of the current trading year from sales made in the previous trading year. This would increase cash, but not affect profit as profit was already recorded in the previous trading year.
- Delayed cash payments until next year. A business received raw materials and other supplies in the current trading year, but does not pay for them until the next trading year. This does not increase cash paid out, but increase costs as costs are recorded in the current trading year. It negatively impacts the profit while the business keeps on keeping the cash.
- New loan is taken. When additional money is introduced into the business in the form of a bank loan or an overdraft, this will certainly increase the cash balance. However, there will be no effect on profit whatsoever. Cash will increase Current Assets in Balance Sheet, but nothing will be changed in Profit and Loss Account (P&L Account) where sales revenue and costs are recorded.
- Fixed Assets are sold for cash. Sale of Fixed Assets such as premises (land and buildings), equipment (machinery) and vehicles will bring in new cash to the business, but have no effect on profit as selling Fixed Assets is not the business’s core activity.
- Huge sales of a new product. A business received plenty of cash after a new product entering the market for the first time turned out to be a hit. However, the business fails to control its costs, especially inflated Fixed Costs of advertising and more rent for retail outlets, meaning that the business will not be profitable. Despite bringing plenty of cash from the sales of one popular product, the business is making an overall loss.
- Opening a new franchise. A new franchise might prove to be a cash-rich business due to a large number of initial customers. However, huge costs involved including initial purchase costs of the franchise (such as buildings and equipment), recruitment of workers and training costs as well as purchasing inventory, may make the business unprofitable. All the capital invested in a business will also increase a cash balance but does increase profit.
- Heavy price reductions. An entrepreneur cuts down the prices of the goods several times during low season as there are only few customers. Even though the firm buys goods on trade credit (not yet paying suppliers for them), they are still recorded as a cost. And, when sold below the Average Cost due to discounts, the business makes a loss. So, the business has a positive cash from selling all the discounted goods even though it is making a loss on them.
4. Not profitable and not liquid
It is possible for a firm to be unprofitable and cash deficient. The is the worst situation when business recording a loss runs out of cash.
- Sell products unprofitably giving very long trade credit. Letting the customers use trade credit to buy products means that customers can buy now but pay later. For example, a trade credit period of 90 days means that customers do not need to pay for their purchases until three months later. This obviously might attract many customers, but can also cause very serious cash flow problems. The business will need to operate for 90 days without receiving any immediate cash payments from its credit customers. In addition to that, the business sells its products at the very low prices while having high costs of production far exceeding the price. In this way, when a firm sells its products on credit without earning any profit on the sale, the business will quickly go bankrupt. Simply, there will be not enough profit to sustain the business in the future, nor enough cash to pay for all the daily costs. That is really bad!
How different types of assents impact liquidity and profitability?
Current Assets improve liquidity but not profitability. An increase in Current Assets helps the company to be more liquid, but not necessarily to be more profitable. A business needs sufficient profitability to be able to reinvest its retained profits in order to expand. It is important for a business to maintain a balance, and fulfill the need for profitability to ensure its long-term growth.
Fixed Assets improve profitability but not liquidity. An increase in Fixed Assets helps the company to be more profitable, but not necessarily to be more liquid. A business needs sufficient liquidity to be able to pay its everyday debts. It is important for a business to maintain a balance, and fulfill the need for liquidity to ensure its short-term survival.
Businesses should keep just enough cash to keep the business running. So, make sure that your Current Ratio is around 1.5. Businesses shall not keep large amounts of cash (Current Ratio above 2). This cash could be used better to invest in revenue-generating assets such as developing new products, opening more shops, hiring more workers, etc.
