How can firms make profits but be short of cash?

What is the difference between cash and profit?

•          Cash is tangible and deals with money flowing in and out of a business.  Profit is a calculation – Revenue – Expenses

Why can firms have large profits and no cash?  Its due to:-

–        Excessive Drawings / Dividends paid out - not recorded  in the Income Statement so profit is unaffected but the firms cash down when paid out

–        Lots of prepayments of expenses – deduct from the expense so profit technically increases but cash goes down

–        Paying off loans - cash goes down and since are loans not in the Income Statement profit is not affected

–        Buying Fixed Assets – treated as Capital Expenditure – so depreciated in the Income Statement but cash may go down by the whole amount

–        Lots of Accrued Income – credit sales are  included in the Income Statement which increases profit but the firms has not yet got the cash)

–        To evaluate this you could mention that, in the short term cash is required to survive but in the longer term profits will need to be generated.

Application tip

·         Always apply to the scenario – quote examples!

·         If asked to calculate the effect always say it will increase or decrease by £xxxx.  Never just give the figure – the direction is important!