Profit is not cash

Two different measurements

Profit, in this page, means net income: revenues and gains minus expenses and losses recognized for a period. Cash means the currency the company holds, including deposits that are cash.

Accrual accounting records the effects of transactions in the period those effects occur, even when the cash is received or paid in a different period. FASB Concepts Statement No. 8, paragraph OB17, gives that as the reason accrual information is useful: a report of only this period's cash receipts and payments is a weaker basis for judging performance. Chapter 7 of the same Concepts Statement, paragraph PR28, draws the consequence for financial reporting: readers need information about the amounts, causes, and timing of the differences between income and cash receipts and payments. That is why cash gets a statement of its own.

The Conceptual Framework explains the objective. It is not itself the rulebook for a particular transaction. The statement that reports cash is specified in ASC 230. That statement classifies cash flows as operating, investing, and financing. Whichever way a business presents operating cash flows, it must reconcile net income to net cash from operating activities. ASC 230-10-45-29 requires the reconciliation, and 45-28 describes how it works. It adjusts for accruals, such as changes in receivables and payables, and for items such as depreciation that reduced profit without using cash.

The practical result is simple. You need both numbers. Net income tells you about performance. The cash account, and the statement of cash flows, tell you about cash.

Example A: a sale on account

This example is hypothetical. Harbor Studio starts the period with $8,000 cash and no receivables. It does one job and pays its wages. Nothing else happens. There is no depreciation in this example.

Harbor performs services and bills the customer $10,000. The customer has not paid.

Account	Debit	Credit
Accounts receivable	$10,000
Service revenue		$10,000
Totals	$10,000	$10,000

Revenue is recognized now. No cash has moved.

Harbor pays wages of $6,000 in cash.

Account	Debit	Credit
Wage expense	$6,000
Cash		$6,000
Totals	$6,000	$6,000

The income statement for the period:

• Revenue: $10,000
• Wage expense: $6,000
• Net income: $4,000

1. Revenue billed$10,000
2. −Wages paid$6,000
3. =Net income$4,000
4. Cash after the same events$2,000

Net income for the period, in currency units. It is not the change in cash.

Revenue

Amount earned in the period under the applicable recognition rule, in currency units. In the example, that is the full billed amount, whether or not it has been collected.

Expenses

Costs recognized in the same period, in currency units. Wages paid in cash are included. A non-cash expense such as depreciation is included only in Example B.

The cash account:

• Beginning cash: $8,000
• Cash paid for wages: $6,000
• Ending cash: $2,000

Profit is $4,000. Cash fell from $8,000 to $2,000. The $10,000 of revenue is sitting in accounts receivable, which is an asset, not cash. Harbor is profitable in the accrual sense and has less cash than it started with.

When the customer later pays the $10,000, Harbor records:

Account	Debit	Credit
Cash	$10,000
Accounts receivable		$10,000
Totals	$10,000	$10,000

One asset becomes another. No revenue or expense account appears.

Net income does not change. The revenue was already recognized. Cash becomes $2,000 + $10,000 = $12,000. Collecting a receivable is a change in the form of an asset, from a receivable to cash. It is not a second helping of profit.

Both rows are the same period's profit. Only the cash and the receivable change in the second row.

1. 1Harbor bills $10,000

   Profit records

   Revenue of $10,000 is recognized. Net income so far: $10,000.

   Cash does

   Nothing. The customer owes $10,000, recorded as accounts receivable.

2. 2Harbor pays $6,000 of wages

   Profit records

   Wage expense of $6,000 is recognized. Net income: $4,000.

   Cash does

   Falls by $6,000, from $8,000 to $2,000.

3. 3The customer pays

   Profit records

   Nothing new. The revenue was recognized at billing. Net income stays $4,000.

   Cash does

   Rises by $10,000, to $12,000. The receivable falls to $0.

Profit is complete after the first two events. Cash is not, until the third.

The table is the example. The panel below it uses the same amounts and lets you apply the collection, or not. You do not need the panel to follow the arithmetic.

Example B: an expense that uses no cash

Keep Harbor's facts, and add one more accrual. Harbor also records $1,000 of depreciation on equipment it already owns. This is a separate illustration, not a third step after the collection in Example A.

Account	Debit	Credit
Depreciation expense	$1,000
Accumulated depreciation		$1,000
Totals	$1,000	$1,000

No cash account appears.

If the customer has not yet paid, the period now looks like this:

• Revenue $10,000 − wages $6,000 − depreciation $1,000 = net income $3,000
• Cash is still $2,000, because depreciation did not pay or receive cash
• Accounts receivable is still $10,000

Profit fell by $1,000 relative to Example A. Cash did not. This is why a reconciliation from net income to operating cash flow adds depreciation back. The add-back removes a non-cash expense so that operating cash flow is not reduced by a cost that was not a cash payment. It does not mean the company received $1,000 from "depreciation." Depreciation is not valuation explains what that expense is doing instead.

Laid out as that reconciliation, with the customer not yet paying, Example B looks like this:

1. Net income$3,000
2. Add back depreciation+$1,000

   Reduced net income, used no cash.

3. Subtract the increase in accounts receivable−$10,000

   Revenue recognized but not yet collected.

4. Cash from operating activities−$6,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Cash from operating activities is −$6,000 in Example B, the same as in Example A, where it is $4,000 of net income less the $10,000 increase in receivables. It matches the cash account in both: $8,000 − $6,000 = $2,000. Adding back depreciation cancels an expense that never used cash. It does not create cash.

How to use the two numbers

Read the income statement and the statement of cash flows as a pair.

If revenue grew and receivables grew by a similar amount, some of the profit has not been collected. If inventory rose, cash may have been spent on goods that are not yet an expense. If payables rose, the company may have recognized costs it has not paid. Those are timing gaps. They can reverse, and they can also become a cash problem if customers pay slowly while bills come due.

Profit is also not "cash the owner can take." Loan payments, equipment purchases, and dividends use cash. Loan principal is not an expense. Buying equipment is not an expense of the whole purchase price in the purchase period; the cost is allocated later if the asset is depreciated. Dividends are distributions to owners, not expenses. A company can show net income and still have no spare cash for any of those uses.

On the cash flow statement, start with cash from operations, then look at investing and financing. A profitable company that is buying equipment or repaying debt can report a decrease in cash for the period. That decrease is not, by itself, evidence that the profit was wrong.

A common misconception

One version is: if the income statement shows a profit, the bank account increased by that amount. Example A is the counterexample. Profit is $4,000 and cash is down $6,000 until the customer pays.

Another version is: depreciation is added on the cash flow statement, so depreciation provides cash. The add-back is a reconciliation item. In Example B, cash does not increase when depreciation is recorded. Cash is unchanged by that entry.

Where this stops

This page describes accrual financial reporting. Some small businesses, and some tax computations, use a cash basis, under which revenue is reported when collected and many expenses when paid. Those reports are built to answer a different question. Do not mix a cash-basis tax figure with an accrual income statement and expect them to match.

Net income is also not comprehensive income. Items of other comprehensive income bypass net income under US GAAP. This page does not catalog those items. The narrower point still holds: neither net income nor comprehensive income is cash flow from operations.

A profit does not mean the company will run out of cash, and a profit does not mean it will not. Example A shows one timing gap in one period. Whether cash becomes tight depends on collections, payroll, inventory, capital spending, debt service, and distributions. The statements give you the inputs. They do not turn profit into a cash forecast.

IFRS, like US GAAP, reports performance on an accrual basis and presents cash flows in a separate statement. The journal entries in the examples are illustrations of the timing difference, not a complete set of financial statements and not a tax filing.