1. What are the five major factors that make Profit and Cash different from each other?
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2. #1 - SALES
The sales income (revenue) is realized, when you send the invoice -> sales affect the Income Statement immediately
However, you receive the payment only after the term of payment -> sales affect your cash with a delay
In VIBu: Sales that you have not yet received to your cash can be found: Internal – Accounts receivable
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3. #2 - EXPENSES
Costs are expenses that belong to the same year: raw materials, labour expenses, energy,…
For example, raw materials costs are realized immediately when you order raw materials – costs affect the Income statement immediately
However, the money actually leaves only after the payment time – costs affects your cash with a delay
In VIBu: Costs that you have not yet paid from the cash: Internal – Accounts payable
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4. #3 – INVENTORY… Which company is more profitable, A or B? Company A B
The inventories were identical in the beginning of the year, the companies sold exactly the same amount of goods with the same price, and the raw material costs/unit are the same – just the number of units purchased is different.
Company A B
Turnover
Raw material purchases
Other costs
Profit ?
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5. #3 - …INVENTORY…
Purchases of materials in the period are all treated initially as expenses (all purchases affect cash)
However, the materials are not all used up in the accounting period => necessary to make an adjustment reducing the expense for stock on hand
The two companies A and B are identical with the only difference that A has bought raw materials worth of and B worth of
Should the result of B be worse, although it has NOT USED the extra raw materials worth of ?
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6. #3 – …INVENTORY…
The income statement is balanced with an item called Change in Inventories
The example assumes that the inventory has been in the beginning of the year.
Company A B
Turnover
- Raw material purchases
- Change in Inventories
- Other costs
= Profit
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7. #3 - …INVENTORY…
In your Cash the raw materials are always paid after the term of payment
In the Income statement all the raw materials are marked as costs but then some of them may be included in Change in Inventories as a positive item, overriding some of the raw material costs
Change in Inventories can also be negative, meaning that inventory has decreased from the beginning of the year. Again this balances the effect of unequal raw material purchases between companies, as no company can show good results based on purchases from the previous period.
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8. #4 - LOANS Having a bank loan is not income from running the business
Paying the loan back to the bank is not a cost of running your business
Loans are shown in your Cash, not in your Income statement
Only the interest from the loans is treated as a cost (shown in the Income statement)
The total amount of loans are shown in your Balance sheet
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9. #5 – investments…
Long-term investments have effect over long periods of time = they are expenses of future years
This is the case when we buy fixed assets: the asset is not used up in the year of purchase, and so it would be unfair to treat the whole payment as an expense of that year
If the machine will last for ten years, the cost is spread over ten years rather than charged totally to the year of purchase
This yearly cost is called a depreciation expense
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10. #5 – …investments… This is how it shows in your cash…
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11. #5 – …investments
This is how it shows in your Income statement (Profit and loss) and Balance sheet
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12. SUMMARY: PROFIT vs CASH
The previous five reasons explain why the cash situation does not reveal the profitability of the business
A company with profitability problems may have a good cash situation, e.g., because of loan taking
A bad cash situation of a profitable business may stem from, e.g. long terms of payments in sales
In any case, the adequacy of cash is a prerequisite for successful business management
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