Cash Flow vs Profit

Cash Flow vs Profit – What’s the difference?

It seems strange, but the easiest way to explain the difference between cash flow vs profit is to look at the balance sheets of a business. The movements between balance sheets is the key to understanding cash flow vs profit.

The table below shows the opening and closing balance sheets of a typical business, and in the final column shows the movement between the two balance sheets. The presentation has been simplified for the purpose of this explanation.

Beginning and Ending Balance Sheets

Cash Flow vs Profit: Beginning and Ending Balance Sheets
Balance sheet Beginning Ending Movement
Fixed Assets 20,000 55,000 35,000
Cash 3,000 7,500 4,500
Accounts receivable 5,000 9,000 4,000
Inventory 4,500 8,000 3,500
Accounts payable -6,000 -8,500 -2,500
Loans -12,000 -45,000 -33,000
Net assets 14,500 26,000 11,500
Capital 10,000 15,000 5,000
Retained earnings 4,500 11,000 6,500
Equity 14,500 26,000 11,500

The Balance Sheet Movements

If we look at the movement column, we can group together accounts receivable, inventory, and accounts payable, as these combined are called the working capital of the business.

Cash Flow vs Profit: Balance Sheet Movements
Balance sheet Movement Explanation
Fixed Assets 35,000 Fixed asset movement
Cash 4,500 Cash Flow
Working capital 5,000 Working capital movement
Loans -33,000 Loan movement
Net assets 11,500
Capital 5,000 New equity capital injected
Retained earnings 6,500 Profit for the year
Equity 11,500

Balance Sheet Movements Rearranged

If we simply rearrange the movements while maintaining the balance on both sides, we get the following.

Cash Flow vs Profit: Balance Sheet Rearranged
Balance sheet Movement Explanation
Cash 4,500 Cash Flow
4,500
Retained earnings 6,500 Profit for the year
Working capital -5,000 Working capital movement
Fixed Assets -35,000 Fixed asset movement
Loans 33,000 Loan movement
Capital 5,000 New equity capital injected
4,500

As both sides are equal (in this case 4,500) we can see that

Cash flow = Profit – Working capital funding – Fixed asset movement + Loan movement + New equity injected

Since we know the following:

1. Fixed asset movement = Capital expenditure – Depreciation
2. Loan movement = New loans + Interest – Loan repayments

We can rearrange the formula to give the following cash flow formula:

Cash flow = (Profit + depreciation + interest) – Working capital funding – Capital expenditure – Loan repayments + New equity + New loans

We now have a formula showing cash flow vs profit and we can see that:

• Cash flow and profit are not the same
• Profit is only one small element of cash flow.
• A business can be profitable but still have a negative cash flow
• If the profit margin is small, it is more important to control working capital (inventory, account receivables, and account payables)
• Capital expenditure needs to be matched by new loans (or new equity) to avoid affecting cash flow.
• As a business grows its working capital funding also grows (inventory and account receivables get higher), and cash flow can rapidly decline unless alternative sources of funding for expansion are found.
• It is important to understand the balance sheet and balance sheet movements to understand and control cash flow.
Cash Flow vs Profit November 6th, 2016

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