The timing of income and expense is imperative. If income exceeds expenses, there will be a profit, but only if there’s enough income to cover expenses and keep the business operating as payments come due.
A good way to learn respect for the concept of cash flow is to compare it to the idea of profit. As a business owner, you understand and strive to make a profit. If a retail business is able to buy a retail item for $1,000 and sell it for $2,000, then it has made a $1,000 profit.
But what if the buyer of the retail item is slow to pay his or her bill, and six months pass before the bill is paid? Using accrual accounting, the retail business still shows a profit, but what about the bills it has to pay during the six months that pass? It will not have the cash to pay them, despite the profit earned on the sale.
As you can see, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat narrow, and only looks at income and expenses at a certain point in time. Cash flow, on the other hand, is more dynamic. It is concerned with the movement of money in and out of a business. More importantly, it is concerned with the time at which the movement of the money takes place.
Truthfully, the concept of cash flow is more in line with reality. If you use the accrual accounting method, it is helpful to know how to convert your accrual profit to your cash flow profit.
- Accrual accounting vs. cash accounting
- Converting accrual profit to cash flow profit
- Changes in accounts receivable
- Changes in inventory
- Changes in accounts payable
- Changes in notes payable
- Profit vs. cash flow
Accrual vs. Cash Accounting
If you keep your books on the cash method of accounting, this section doesn’t apply. If, however, you keep your books on the accrual method of accounting, then please read on.
Without waging into the details of accrual accounting, understand that it is an essential tool for the financial management of your business. Primarily, it shows the performance of your business over a period of time by matching income and expenses.
Regardless of the cash flow, the accrual method of accounting recognizes income when a sale is made. Likewise, it recognizes an expense when the expense is incurred. Most accountants recommend using the accrual method because they feel that it is the most accurate method for measuring how your business is doing. In fact, for some types of businesses, you must use the accrual method.
However, accrual accounting does have some drawbacks. The main disadvantage being the timing difference it creates between the recognition of income and expense transactions, and the actual inflows and outflows of cash.
The cash method of accounting records the actual flow of cash through a business. It recognizes income when cash is actually collected from a sale. It recognizes expenses when cash is actually paid out, or when a check is written to pay a bill. It is not concerned with matching income and expenses, but rather the actual inflows and outflows of cash. This method of accounting more closely resembles your cash flow.
Converting Profit to Cash Flow
If you keep your books on the accrual method of accounting, you’ll have to make some adjustments to determine your actual cash flow. These adjustments are necessary due to certain expenses taken into account to determine your accrual net profit, even though these expenses do not currently require a cash outlay. To convert your accrual profit to your cash flow profit, you need a balance sheet for the beginning and end of the period under examination.