How a profitable business can run out of cash
/Profit is not the same as cash. A business may report robust profits, and yet be quite short of cash. This can cause significant problems, especially when company managers mistakenly equate profits with cash, and suddenly find themselves out of cash and the company in bankruptcy. There are several reasons for this problem, as noted below.
The Impact of Accrual Accounting
Most larger firms record their accounting transactions using the accrual basis of accounting, which mandates that revenues be recorded when earned and expenses recorded when incurred. The problem is that revenue may be earned well in advance of the related cash receipt. Similarly, the recordation of an expense does not necessarily equate to the disbursement cash.
Excessive Capital Expenditures
Another issue is the recordation of more expensive assets as fixed assets, rather than charging them to expense when purchased. Instead, they are initially recorded as assets and then depreciated, so that the related expense is not entirely flushed out through the income statement for years. This means that a business could pay out massive amounts of cash and yet still report a profit, because the related fixed assets are not yet considered to be an expense.
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Poor Inventory Management
A business might have tied up too much of its cash to take advantage of volume purchase discounts for its inventory. In many cases, it makes more sense to buy in smaller quantities, despite losing a volume discount. This is especially true when the inventory is subject to obsolescence in the near term. This issue can also be remediated by keeping a close watch on inventory levels and selling off excess inventory - even if doing so will result in a loss on the sold items.
Long Credit Terms
A company may offer its customers generous credit terms, so that they do not have to pay for their purchases for an extended period of time. In this case, the company may have recorded substantial sales to these customers, and yet there is no corresponding cash inflow - perhaps not for one or two months. Conversely, if a company has powerful suppliers, they can insist on quite rapid payment terms, so that the company has to pay its suppliers before it has received any money from its customers.
The supplier problem is especially acute in the areas of employee compensation, payroll tax remittances, rent payments, and insurance payments. In all four cases, the business has to pay within a short period of time, and probably well in advance of payments from its customers.
The Statement of Cash Flows
To spot the impact of these problems, you should always review a company’s statement of cash flows. It reveals the cash inflows and outflows of the business, within the categories of cash related to operations, investing activities, and financing activities. When a net cash outflow is stated on this report, despite the presence of reported profits, it is a strong indicator of deep underlying problems that require investigation. A sample presentation of a statement of cash flows appears in the following exhibit.
