Profit vs. cash flow

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Profit vs. cash flow

Following one of our former articles, profit does not equal profit, we would like to address a related topic: the difference between profit and cash flow.

When companies make profits, this does not necessarily mean that they have more money in their accounts. A profit of 10 million does not mean that the company now has 10 million more cash, neither in hand nor in bank balances. Sounds confusing at first, because normally you have more money if you make profits, don’t you?

In order to find the answer to this problem, you have to look at how the profit is achieved.

Profits are determined according to the double-entry accounting system. However, the profit or loss in the double-entry accounting system is not determined exclusively by incoming or outgoing payments. There are a number of rules in double-entry accounting and it is therefore difficult to compare corporate accounting with “household books”.

Depreciation

The most common examples are for example depreciation on buildings, machinery or securities. In double-entry accounting, for example, a machine that is expected to be in service for 4 years and has been purchased for €40,000 is not recorded with the full expense of €40,000. The machine is depreciated evenly over the (planned) period of use of 4 years – the profit is thus reduced by 10,000 euros annually.

Therefore, there is a difference between the profit according to the double-entry accounting regulations and the actual cash flow. In mathematical terms, it looks like this:

  • 1st year: 40.000 € flow out of the company, because the machine has to be paid. In double-entry accounting, however, only €10,000 are booked as expenditure. This results in a difference of 30,000 €, which the company has less at its disposal than the double-entry accounting would suggest.
  • 2nd – 4th year: Since the machine has already been paid for in the 1st year, no money flows out of the company in years 2-4, so the cash flow is not affected. The profit and loss account, however, is charged with 10,000 € expenditure every year, without the actual money being paid.

Consequently, it may happen that a company makes splendid profits, but earns practically no money and thus at some point has no cash left to pay its bills and becomes insolvent.

Appreciation in value

Even worse than this “shift” of expenses, however, can be profits that are purely accounting profits. For example, a real estate company can achieve horrendous profits by appreciations – the opposite of depreciations – on its properties, but rental income does not actually increase.

A real estate company can therefore have the assumption that its properties have increased in value. If the company and/or an expert come to the conclusion that the property is now worth 1 million euros more, this results in a (surplus) profit of 1 million euros according to the income statement – without even one cent extra ending up in the company’s bank accounts!

Conclusion for a small investor

When reading corporate news or analysis, there is a lot of conversation about “earnings per share” (EPS). It is perfectly natural that earnings per share are not identical to cash flow per share. However, you should always pay attention to where the reported earnings come from. Do really deals that the company has closed make up the majority of the profit or is it mainly achieved due to appreciation or accounting tricks?

In addition, as with the concept of profit, there are several “types” of cash flow that we do not need to go into in detail about. Therefore, you should become suspicious if the company is making high profits but the cash flow is lagging behind.

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