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Profit vs. Cash Flow Made Easy

Posted on August 23rd, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In a previous article, I mentioned a client that made this comment to me:  “I wish I knew where the money went!  I didn’t take any more salary, but I’m paying a lot more in taxes.”  I then went on in that article and briefly explained the importance of profit, and how it differs from “cash flow,” and financial reporting for tax purposes.

Another thing I did for that client was to create a set of financial statements in a format that he could see more clearly the relationship between his Profit & Loss Statement and his Cash Flow Statement, and it was almost like an “ah HA” moment for him.  The financial statements I gave him were like those of this fictitious company:  “Larry’s Bankruptcy Strategies, Inc.”  This name was chosen (with a little tongue in cheek, of course) because of the various accounting transactions I built into the financials in order to illustrate many of the things a business owner can do to drive his company into bankruptcy:

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First note the $70,351 “Loss” on the company’s P&L. This should be fairly self-explanatory.  Obviously (assuming an accrual basis of accounting), their expenses exceeded their income.  And note in particular the Payroll Expenses.  It’s not often that you see the payroll exceeding the total sales of the company, unless it’s a start-up company and very well capitalized by the owner as this company was (at first, stay tuned).

Next, refer to the Balance Sheet.  This is where the special formatting comes in.  Notice the “variances” between year one and year two.  You don’t often see these calculations on CPA-prepared balance sheets for third-party users such as banks, but this is where the other components of the cash flow statement come from.  These are the rules that apply:

  • An increase in an asset account is a use of funds (i.e., money out, such as an increase in accounts receivable reflecting uncollected sales, the purchase of an asset, or money lent out to the owner)
  • A decrease in an asset is a source of funds (i.e., money in, such as a net decrease in accounts receivable reflecting collected sales, the sale of an asset, or money paid back to the company such as on loans to the the owner)
  • An increase in a liability account is a source of funds (i.e., money in, such as an increase in accounts payable to fund inventory purchases, a loan to the company, or equity from the owner)
  • A decrease in a liability account is a use of funds, (i.e., net payment of accounts payable, principal payments on loans, or money taken back out by the owner).

Now, look at the “Statement of Cash Flows.”  It starts with the profit or loss from the profit and loss statement, then, all of the above changes in the balance sheet accounts are added to or subtracted from that number.  So following down the cash flow statement, in addition to losing money, our “entrepreneur” here, Larry, allowed a large amount of accounts receivable to go unpaid, and bought an excessive amount of inventory on credit from suppliers and credit cards (more on accounts receivable, inventory, and accounts payable turnover in a future article).  And this was all while paying himself back the $175,516 loan he originally made to the company, leaving a negative balance in his checking account of $13,152 (i. e., book or bank overdraft).

And there you have it.  That’s all there is to it.  Once more, the main lesson to learn from this exercise is that a “loss” truly is a use of funds, and the importance of profit in helping to fund your other balance sheet uses of funds.  Sooner or later if these financial relationships continue to be ignored, it’s going to hit your pocketbook, or that of a critical supplier, or your bank.  So beware, if all you’re focused on is avoiding taxes, ultimately, the joke is on YOU.  But in order to truly understand what’s going on in your business, you have to look at both profit AND cash flow.

 Related Articles

Analyzing the Components of Cash Flow

Can Paying Taxes Be a Good Problem?

 

 


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