I know most know this but for some unknown reason I kept getting these two mixed up when writing posts on HC.
So had to jam it into my head once and for all. ts so simple and obvious and could be explained in 1 sentence so I dont know why I kept misquoting them.
From Yahoo answers or some such:
"For a business to be successful, an ideal situation is to have adequate cash balances as well as healthy profit figures, i.e., it should strive to be profitable and cash generative. There is often a great deal of confusion over these two terms as many think that these are similar terminologies used interchangeably. However, what needs to be learnt is that 'profit is not the same as cash.' There are multiples reasons as to why the profit shown in the income statement may not be same as the amount available in the company's bank account to spend. The profit may be a positive figure but cash balance may be a negative figure.
Cash and Profits
The word profit comes from a Latin word meaning 'to make progress.' It is the most important measure of a company's success and is highly reflective of its development, status and wealth. Cash is more like an organization's engine on which the company runs. If cash management is not up to the mark, the company is likely to go bankrupt. Moreover, high profits do not in any way mean that it is free cash available that the owner can easily draw out as a salary. Cash flow analysis gives an insight into the core business activities and management decisions on which the company's profitability and sustainability linger. For companies, often profit is the overriding objective but if cash is not sufficient, the company's growth will slump and there may be a threat to its survival. Hence, cash flow is absolutely critical for the existence and survival of an organization and a company generating healthy cash balances will invariably have high profitability. To put in another way, cash is a need whereas profit is a want.
The company's cash calculation is shown in the Cash Flow Statement whereas the profit Calculation is shown in the Income Statement or the Profit and Loss Account.
Reasons why cash and profit are different
One of the major reasons why there is discrepancy between cash and profit figures is the difference in the timing of when a sale is made and cash is received. This is the most general case as companies tend to sell their items to customers on credit basis rather than on cash basis. As per the credit terms, the item is sold whereas the cash is not received until the next few months. The sales figure is transported to the Income Statement whereas the cash received is not entered in the Cash Flow Statement until the cash is received. As a result, there is a natural time delay due to which cash and profits tend to differ.
The idea stated above is that not all revenues and expenses reflect the timing of cash and payment. The income statement reflects all the expenses and revenues occurring within a period which may be six months or a year which may or may not reflect the cash flow into or out of the business. There are many expenses that occur within the period but are still arrears that is, they have not been paid for as yet and stand as a liability for the company. An example is interest expense that is particular for that accounting period but has not been paid and hence is an accrued expense. Similarly, there maybe revenues such as rental income that are specific for that current accounting period but the tenant has not yet paid the company for it. As a result, it is an account receivable as cash has not been received for it. These unearned revenues and accrued expenses are shown in the Income Statement but have no reflection in the Cash Flow Statement.
Similarly, there are prepaid expenses for which the expense has not yet been incurred as it belongs to later accounting periods but the company pays out cash to settle the expense in advance. Also, there are advances received or the accounting term unearned income for different incomes such as rental incomes which do not belong to that accounting period but for which the tenant has paid us in advance. Prepaid expenses and unearned incomes are not reflected in the calculation of profit but are shown in the Cash Flow Statement as they depict the movement of cash into and out of the business.
Another reason for the discrepancy between cash and profit figure is the existence of closing stock which is accounted for in the Income Statement but not the Cash Flow Statement. Closing stock is the amount of inventory or items unsold by a company at the end of the accounting period which does not reflect any movement of cash but is shown in the income statement.
Yet another reason for the difference in cash and profit is that certain non-cash expenses are used in the calculation of the company's net profit. Non-cash expenses are those that do not involve any cash movement into and out of the firm. Depreciation which is the wear and tear in the life of an asset is one such non-cash expense which is used in the Income Statement but not shown in the Cash Flow Statement. Gain or loss on the sale of fixed assets is another non-cash expense which is recognized in the Income Statement but not in the Cash flow statement. The Cash Flow Statement records the entire proceeds from the sale of an asset but not the gain or loss which is reflected in the Income Statement. Hence, not all the transactions shown in the Income Statement reflect the movement of cash in the company.
Importance of cash and profits
The reason why so many companies give so much time to managing their cash balances and also ensuring healthy profits is to allow for the company to be run smoothly with enough liquidity and at the same time ensuring that owners and stakeholders are happy with the performance of the company.
Cash is critical for the company and so there should be enough available for the easy daily running of the business. It needs to be managed effectively as well. E.g. a company may tie up all its cash in unused inventory and have no balance available to pay off daily expenses. Similarly, a company may allow too long a credit period to debtors and find out that it is severely in need of cash in the interval periods as customers will pay at a much later date. Hence, cash is like the backbone of any company as without it, it may face severe liquidity problem and end in a major cash crisis.
Profit is the most important indicator of business success. If a business incurs losses, it may as well go out of business in some time as the owners or shareholders will attach no or little value to the company as benefiting them and they may come to the conclusion that quitting the business may be a better option. The owners will be highly dissatisfied over continuous low or no profits and the company will loose its image in the eyes of general public, which will eventually lead to the event of ceasing the company altogether.
Therefore, it is extremely important that both profit and cash are positive figures and there is a balance between them. Even if the company lacks on either one of them, the company is likely to loose out in the market place. Hence, for a company to be successful and to have the potential to grow, it has to be starkly mindful of its cash position and profitability."
