Why Cash & Profits are Different

Profit is not cash.

I’m going to prove this using a very simple example.

We run a shop selling phones.

• Our phone shop sells a phone to Jane for $200.
• The phone’s original cost to the phone shop to acquire the phone was $120.
• Jane takes the phone home but we give her 7 c-day credit terms.
• She is only able to pay for the phone in 7 days.

On the day of the sale:

• Cash received by our phone shop was: $0
• Income earned by the phone shop was: $200
• Expenses incurred by the phone shop was $120
• Profit earned by the phone shop was: $80

There we have it - a profit was earned on the day of the sale of $80 yet cash received $0!!

Profit is NOT cash.

If you’re confused, you’re not alone. Many non-finance managers are confused by this scenario.

It’s because they are not aware of how accrual accounting works.

According to the principles of accrual accounting, we recognize income when the service is performed and we recognize expenses when the usage of a particular service occurred.

In the example above, income was earned because we rendered the service - Jane has possession of the phone which we sold to her.?

We also record an expense because the inventory we had - the phone worth $120 - has been used up. We no longer have that inventory. Jane has it.

As I've demonstrated, because of accrual accounting, profit cannot be the same as cash. We could have a very high cash balance and have made losses (if customers paid us upfront or we raised money from shareholders or sold a non-current asset) or have very high profits but very little or no cash (if we have sold to customers on credit who have not yet paid us)

If you'd like to learn more about accrual accounting, take a look at these two videos on when we record income and expenses from an accrual accounting point of view:

An understanding of accrual accounting helps non-finance managers understand how to read a P&L and make sense of EBITDA.

Have a fantastic day.

Best,

Mark

www.accountingmadeeasy.co

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