The Difference Between Profits and Cash

Let's return for a moment to your income statement, and your business's revenues, expenses, and profits. You might think that the profits you make would feed the cash component of your assets. In theory, this could be the caseespecially if you run a relatively small, relatively simple business. However, two factors can make these two numbers get out of whack.

First, you probably don't pay all your bills on the day you receive them. When a bill is due but you haven't paid it yet, you have created a liability, which will change your asset position. Let's use an example in which you start with zero assets and zero liabilities. You sell an item for $5 and, after subtracting $2 cost of goods sold, generate a $3 gross profit. That $3 in your pocket is both cash and assetuntil you receive a bill from eBay for $1 worth of fees. Now you have a $1 liabilityand a $1 expense. Even though you haven't paid the bill yet, you still have to figure the expense, which reduces your net profit to $2. You still have $3 in cash, but your profit is now just $2. So, for the time being, your cash doesn't equal your profit. (This will be rectified as soon as you write a check for $1 to eBay, of course.)

The second way in which cash and profits differ is if you accept payment on credit. Let's say you sold that $5 item (which generated a $3 gross profit) to Mr. Smith, who signed the invoice and promised to pay within 30 days. Now you have a $3 profit but zero dollars in cashand you won't have the cash until Mr. Smith sends you a check later this month.

This is all to demonstrate why you must look at your cash situation as being separate from your profitsas tempting as it might be to think that your monthly profits would equate to real cash on hand.

Note

The $5 due from Mr. Smith becomes an asset on your books, in the form of an accounts receivable.

Just because you have a certain amount of cash in the bank doesn't mean that all that cash is yours. Some of it may have to be used to pay future bills.