A Negative Net Cash Flow From Operating Activities Indicates Equating Profitability With Cashflows: A Myth in Corporate Financial Performance

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Equating Profitability With Cashflows: A Myth in Corporate Financial Performance

The issue of profit and cashflow and their respective importance in business has become an unending discussion in recent boardroom discussions. As some analyst are looking at profit history of business to assess performance, others are looking at the cash movements (i.e. cashflows). People even get more confuse when a profitable business on one hand is not able to pay its suppliers or expand whiles a non-profitable business (i.e. loss) continues to stay in business. The income statement and the cashflow statement of every business has the clue to this issue of profitability and cashflow.

Cash flow is the difference between the amount of cash a company receives and pays, whereas profitability is the difference between revenues and expenses and every company report on both their cash holdings and profitability as part of its financial reporting. Certain cash flows cannot be recorded as revenues or expenses at the time of the transactions, while other cash flows may not be part of the operating activities, and thus are not profit related.

Concept of Profitability in Business

The success of a small business depends on its ability to continually earn profits. Profit basically equals a company’s revenues minus expenses and is critical for businesses because it determines whether a company can secure external financing, attract more investors or grow its operations. A business owner must understand the importance of profitability in business management and develop strategies that give his company the best chance at remaining profitable as that is its main goal for existence among other goals.

Relevance of Profitability in Business

Profits stimulate investment and innovation and as a business undertakes more investment, it leads to generation of more employment. With generation of employment income, more demand for goods in the market will be created.

Profit is regarded necessary for business survival and growth and a business that does not make enough profit is not likely to survive in a growing competitive environment because it enables the business to grow, motivate employee, attracts investors etc.

Profit is a return on investment and every firm invest money with the expectation of higher returns on their investment. Just like shareholders expect higher returns in the form of dividend so do financial institutions expect better rate of interest on the loan given to the business enterprise.

Profit is used test the efficiency of a business and the success or otherwise of the business can be judged by the extent of profit earning capacity.

Profit serves as buffer to meet unexpected expenditures and as a business is exposed to many risk and uncertainties including changing market demands and conditions etc., profit is used to meet such unfavorable business changes.

Retained profit serves as a form of internal financing and can be used for increasing the volume of business through expansion and diversification. Any further surplus is re-invested in the business for further development.

The Concept of Cashflow

The old-age saying, “cash is king” which is usually used to explain the failure of both businesses and consumer households remains relevant in modern business because without proper amount of cash on hand, entities can run into major trouble, and even be forced into bankruptcy. Cash inflow is the lifeblood of every business and businesses need cash for various reasons including investing in new infrastructure and dealing with unexpected expenses. Moreover, a key factor in a business’s potential for long-term success is cashflow and as such a company may have all the revenue in the world, but without the ability to generate cash, it can easily fail. Without cash a business won’t run, resulting in employees becoming cranky and suppliers ceasing to supply materials even though the business may be very profitable. Sources of cashflow include receipts from customers, additions to capital, payments to suppliers etc.

Relevance of Cashflow in Business

For a company to grow, it will often need to make capital expenditure investments in areas such as factories, machinery, or technology etc which are usually a one-time cost and require significant funds, but without cash on hand, a business may not be able to make these necessary investments and, as a result, may never be able to experience company growth. Even where loans are used, the loan agreement will require a significant down payment or periodic interest payment which will in turn require that the company have access to cash.

Businesses can undertake mergers or acquisition as an expansion strategy either within their niche or to branch out into new areas but without the necessary cash, it would never be able to take that opportunity to buy a valuable company at a reasonable price. Acquisitions like these offer growth potential for many businesses.

Two key benefits of holding shares is dividends and share repurchases. Dividends puts cash in the pocket of shareholders whiles share repurchase is a management way of expressing confidence in the business growth potential via share valuation. However, without cash neither dividends nor share repurchases would be possible for a public company.

Every company experiences economic downtimes at some period in operation which could affect its sales and with cash, the company will be more flexible and able to survive the downturn but without readily available cash, it may be forced to wind up, downsize its staff or even be declared bankrupt.

Businesses like individuals also face emergencies for expenses that require immediate payment like legal fees and unexpected costs associated with natural occurrences and as most of these are not budgeted for, it means businesses must have access to the necessary cash to prepare for such emergencies, and without cash, the business may fall flat.

Businesses are expected to minimise cost and one way to do this is to reduce a lot of online transactions processing which comes with a lot of excessive fees and to use cash instead where appropriate. By paying cash, a business can reduce its online fees and ultimately cut transaction costs to the minimum with surplus cash for other productive activities.

Readily available cash helps businesses expand in the absence of loans. Many businesses have difficulty accessing loans for expansion but if it has cash available, it can position itself to take advantage of opportunities to expand and make relevant decisions.

Cash is essential for paying bills faster to avoid unnecessary penalties because paying creditors with forms other than cash can take longer to process, leading to unnecessary late fees and it makes more sense that paying in cash is the preferred method.

Are there any differences between Profitability and Cashflow? YES!

The differences between these business concepts is in recording of Non-Cash Revenue, Non-Cash Expense, Financing & Investing transactions. Companies may see increased profitability from non-cash revenues, but such an increase in profitability will have no impact on company cash holdings because companies record revenues when earned using the accrual method of accounting, despite no cash received and when cash is later collected for previously recorded revenues, increases company cash holdings but will have no impact on the profitability again. Non-cash revenue incudes accrued income, credit sales, gains and profit on disposals etc. Also, companies may see decreased profitability because of non-cash expenses, which will have no impact on company cash holdings. Companies record expenses when incurred using the accrual method of accounting, despite no cash paid and when cash payments are made later for previously recorded expenses, it decreases company cash holdings without affecting profitability.

Other differences are:

  • Money invested in a business, or borrowed by a business, increases cash BUT does not increase profit
  • Capital expenditures, such as buying a new machine, decreases cash BUT does not decrease profit
  • Profit accounts for overheads on accrual and prepayment basis whiles cashflows accounts for overheads when cash is paid
  • Cashflows reflect the details of incoming and outgoing flows of cash without using estimations of allocations and provisions like depreciation, bad debts etc. BUT profit is associated with a lot of such allocations and provisions

Conclusion

When you imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be because we are trained to think of business as sales minus costs and expenses, which is profit but cash is equally critical yet people always think in profits instead of cash and interestingly we don’t spend the profits in a business, we spend cash instead.

Desist from thinking that making profit increases cash the same amount because a business’s cash flow can be considerably higher than bottom-line profit, or considerably lower and know that cash flow can be negative when you earn a profit or positive when you have a loss because there’s no natural correlation between profit and cash flow. It’s thus prudent for businesses to remember that cash pays the day-to-day expenses, not profit and is important for the business always. Profit becomes more important for the long-term success of the business.

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