Translating an inspired idea into a robust business plan
009 The Difference Between Profit and Cash Generation
The operating profit for companies A and B are the same, i.e. the companies are equally profitable. However, company B had old production equipment which had to be replaced during the year resulting in $10,000 of capital expenditure (capex). Therefore the cash at bank at the end of the year is $5,000 lower than at the start. In contrast for company A the bank balance at the end of the year is $ 5,000 higher than at the start of the year. Company A generated $5,000 in of cash. Company B was $5,000 cash flow negative.
A situation could even arise where a company is profitable, but cash flow negative because capital expenditure exceeds operating profit or EBITDA. Indeed this is quite common for businesses which require heavy investment in fixed assets.
Another factor that could make a material difference is timing of cash receipts and cash payments. If a business makes many sales are on credit, the business may book a profit but the customer might not make payment 30, 45 or even 90 days later. If, in the meantime, such a profitable business needs to pay wages, rent, etc. but does not have the cash in the bank, it would become insolvent although it is a profitable business.
Therefore, when you evaluate a company or plan a business, always take a close look at the cash flow statement. New businesses in particular are prone to become insolvent not because they are not profitable but because they encounter a cash flow problem. Profit is one thing and cash generation is another.