Profits Are Not Cash

Imagine we’re looking at a cafe that looks successful. Sales are going up yet strangely it is struggling. This is what we see. The owner tells me it doesn’t make any sense. It feels like they’re doing well, but when it comes time to pay the bills they’re struggling.

How is it possible to be profitable yet chronically short of cash, and in danger of not being able to make payroll and not being able to pay off your suppliers when the bills come? This is something that can happen to a lot of companies.

What’s important to understand in business is that cash is the oxygen. Without it you can’t survive. You can survive a little while without having profits, but you cannot survive if you need cash and don’t have it.

Where the mismatch comes from

Let’s talk about economic activity and the mismatch there can be with cash.

If there’s a credit sale where you close a deal, you didn’t get cash. You get a commitment of some kind of future payment, which is valuable. You are going to see a sale and that’s good for profits, but the cash isn’t in here yet. And if you need it, it’s not going to help you that you’re going to get paid later.

Then there’s a time where the money leaves now even though the benefits are going to come for a while. You pay rent on the first of the month because rent is due on the first of the month, and the cash is gone. All of it. For the entire month. The good news is you’ve got use of your location for the rest of the month. The bad news is all that hit came up front and early, before you’ve had a chance to make the money on having that location in the first place.

Both these can create mismatches in the timing of when the cash leaves your hands versus when the economic benefit is recorded in the income statement.

Why we keep score with profit anyway

We keep scoring business, ironically, by profit, and we get obsessed with it. We want to have more profits, higher profits, because that’s how we keep score - more capturing the economic reality.

Here’s the thing: you can go some time without earning profits, but you cannot survive without cash. You need cash. Cash is like oxygen. If you get cut off, bad things happen quick. You pay bills in cash. Employees and suppliers need to get paid in cash. You have to make payroll on time. If these people don’t get paid on time, they suffer and your credibility suffers.

Until this point we’ve talked a lot about accrual. We’ve talked about how we recognize revenues or recognize expenses depending on when we fulfill our obligation, and when we can take in accounts receivable even if we haven’t gotten the cash yet. When we are doing expenses it matters when we’ve earned this revenue, so the stuff that we paid for as that expense finally gets recognized, because we can respect the matching principle.

All of those things create the need for creating estimates, for creating pro ratings, for matching up expenses and revenue, even if we are not talking about the time when the cash came in but when the economic activity took place and we matched them up together.

That comes with a bunch of assumptions, estimates, allocations, and accruals that we do in accounting, so we can look at financial statements and say that this is a reflection of economic performance. That’s why we do accrual-based accounting.

Why that is not enough

At the same time, cash is so important to manage that we have to have a very clear idea of when cash goes and where cash comes in and what drives that, where it is assumption-free. We can look into our bank statement and see whether or not that cash is there.

So that’s what we have the cash flow statement for. It tells us what our current cash balance is, and it reconciles all the different ways we used it, whether that’s operating activities, investment activities, or financing activities.

It’s important to manage, so we need a statement for it. It doesn’t tell you about performance, because it breaks all of this matching and accrual-based accounting that we learned how to do in the income statement. It only looks at when cash goes and where it goes at the time that cash leaves, so we can manage that scarce asset very carefully.

The two camps, and why both of them are nonsense

Now some people think, “Cash is a terrible way of looking at it. We’ve done so much work to come up with a good income statement.” The principle behind it is that you need to use these accruals to understand the economic activity of what’s going on. If we mismatch revenues and expenses, we don’t understand where that revenue came from, and we can get a bad idea of the profitability of this. At the same time, if you have done the work already, we should be recognizing that, because you’ve produced the good or service. Now it’s a matter of timing differences of when the payment comes in. Coming in is arbitrary. It doesn’t change that you’ve done the work or not, as long as you can collect it. Why are we talking about performance being higher because we collect on things a little bit earlier versus a little bit later?

Now the cash flow side says, “All this stuff that you’re talking about with accounting is all made up: all these assumptions and accruals and timings and matching. That’s not how the world works. Money comes in and money leaves when it comes in and when it leaves, and we should be tracking that because it’s important.” Some people are 100% aligned to cash flow. Cash flow is the only thing that’s true, and accounting has so many assumptions that it’s basically all made up too, too easy to manipulate, too dangerous to rely on.

So both these things are nonsense. We need different perspectives. The income statement helps us understand performance, and how the decisions we make to create economic activity translate into durable value creation, profits, and thriving. Without that we don’t understand how the pieces work together to create value and run a successful business.

At the same time we need to manage cash very carefully, and we need to have a clear-eyed view of what’s what there. We need that second perspective that’s taking a look at this one particular asset and how we manage it, which is how the cash comes in and out, and what drives that, to make sure that we’re never in the embarrassing situation where we need to have some cash and we can’t make it work. Everything that we’re creating, all this value that we’re creating, comes tumbling down because of a credibility issue.

Now some people can run a business totally on cash. It’s not profits until the cold hard cash is in my warm hands. Otherwise I act like I haven’t done anything at all. While that’s a conservative way of living your life, it doesn’t give you insights into how your activities and behaviors create value, because there’s too much distortion from the timing difference.

Everything is fine if things move fast from the time you buy something. You have the good. There are no delays in getting paid, and a transaction always happens at the point of sale. But a lot of transactions happen where there’s a delay between when the benefits come, and when the cash leaves our hands, and when we’ve earned these revenues. There are all these timing differences. If we only look at one part of that, which is when cash goes or comes, we can run the risk of mismatching things and misattributing things, and not having a clear idea of economically what’s going on and whether or not we’re creating value.

It is possible to be profitable and go bankrupt

It is possible to be profitable and still have the business go under through bankruptcy. How’s that possible?

Imagine you were a person who sold on very generous credit terms, and every single time you sell you allow people two months to pay you back. As you grow you’re getting more and more sales, but you know it’s going to come later. However, when it comes to buying stuff, you buy with very strict terms where you have to pay back very quickly.

As you grow you can’t put enough cash in this to front-load all of the stuff that you need to buy, because the money that you can buy the next round with hasn’t arrived yet. What can actually happen is this mis-timing can set you up for failure. Even though you’re creating a lot of value, you’re selling stuff, people like your things and it’s profitable, you’re not managing cash effectively enough to be able to keep the things going. Unless you create a big infusion of cash to tide you over until the next payment, you are going to run out of cash, and therefore the business is going to come to a grinding halt.

Growth eats cash

We see this almost ironically as a consequence of growth. When a small business grows fast, it starts eating up cash, because you grow, you have to buy more equipment, more inventory, perhaps hire more people, and all of this comes in the form of upfront cost. The benefits might be coming later. If you’re growing fast, all of these costs are coming forward, but the benefits, if they lag, create a pinch point of not having enough cash.

It turns out that businesses that are growing have to ratchet up the amount of inventory and the amount of people, so that’s going to be payroll, or, as they grow, they have to have more generous terms and their customers need more time to pay them back. All this puts demands on cash. Unless you find some paid-in capital, some way to infuse more cash in it, you run out, and that limits your growth.

What often happens is the error, especially for entrepreneurs, is that they assume that where they’re at in the relationship of things is a good proxy of the future. Whatever their profitability is now and their cash needs are now, if it’s fine now, I’ll be fine later. The other thing is that growth is always good, and if you grow and you’re profitable now, that could only mean you can get more profits later. But that’s an error, because to grow you need to have more working capital to make it. We often need to incur expenses and cash outlays before the benefits come. If you go fast, that grows faster than the timing of the cash that comes in, so the cash that comes in trickles in a little bit too late while all the money is leaving up front.

To grow you actually need to put more cash into your business, because you can’t wait for the business growth to generate the cash that you could reap and reinvest. You could grow based on the earnings of your business, but you’d have to grow at a slower rate, because you have to wait until the cash comes in.

What cash is good for, and what it hides

One thing that’s nice about the cash flow statement is that cash is hard to manipulate. There are no assumptions about what is depreciable and what is not. There are no assumptions about accruals. There are no earnings that are like “Did we earn this? What are the terms? Is this person going to pay us in two months or one month? What is our policy?”

When you look at a cash flow statement, it’s close to the reality of it, and that’s what’s nice. It’s harder to manipulate, and that’s why a lot of finance people like to focus on that. The only issue is that it’s harder to get an insight into what is economically happening, how the business actually generates value, because you’ve broken the connection between costs and expenses and the revenues that they create.

It is all a timing difference

Notice this is all about a timing difference. If you go out far enough, eventually profits and the cash flow statement converge, because the timing differences evaporate. The receivables eventually get collected, and investments eventually mature.

All of that is about eventually. However, that doesn’t get your payroll paid. If you’re going to get paid later and you need the cash now, that doesn’t help you.

All of this is about timing difference, but those timing differences are super important.

© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.