Navigating the Paradox of Profit: Why a Healthy P&L Doesn't Always Mean Positive Cash Flow

May 12, 2023

Your business is coming off of a challenging season, but you've consistently managed to turn a profit every month! At least, that's what your Profit & Loss (P&L) shows.

When you go to run payroll, you notice your bank account is low.

Low enough that you won't be able to pay all of your employees this week.

What happened?

You may have had a tough few months, but you should have more money in your bank account thanks to the profit you've been seeing!

Why don't you have enough?

While uncomfortable and unfortunate, this scenario is more common for entrepreneurs than most think. Business owners often run into issues and wonder why their company faces cash flow issues even though their P&L shows a profit.

After all, profit equals cash in the bank, right?

Well, not always.

Let's delve into the paradox of profit.

Why Your P&L Isn't the Full Picture

Your P&L statement, while a crucial document, provides only a snapshot of your company's profitability over a specific period.

Specifically, your Profit and Loss details two things: your income and expenses.

This financial statement is geared toward helping you understand whether you're making money. But it doesn't account for all cash inflows and outflows.

For example, it doesn't reflect capital expenditures, loan repayments, or owner's draw.

While these things are outflows of cash from your business bank account, they're not expenses to the company. According to the IRS, business expenses are the ordinary and necessary costs incurred to operate your business. Paying back debt or distributing money to an owner is not usually a deductible expense.

Instead, these outflows of cash show up in your Balance Sheet. They solely interact with your Assets, Liabilities, and Equity.

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Understanding The Balance Sheet: Equity

The balance sheet provides a broad view of your company's financial health. It's a snapshot of your company's Assets, Liabilities, and Equity at a given point in time.

The balance that you have in the bank, the amounts remaining on your loans, or the balance of a credit card; these things are all reflected on your Balance Sheet.

Equity can be a difficult component of the Balance Sheet to fully understand.

At the most basic level, equity is a calculation of Assets minus Liabilities. It's the residual interest in the assets of your business after deducting liabilities.

Equity is what you, as the business owner, would theoretically have left if you sold all the assets and paid off all the debts. The value of the business after all obligations have been settled.

Equity also lists out any owner's draw or distributions of cash that have come out of the business. When cash is transferred from a business account to a personal account in most cases, that transaction is recognized as a distribution of equity.

While the equity section reflects the owner's investment and retained earnings, it doesn't necessarily equate to cash available for business operations.

Understanding The Balance Sheet: Liabilities

Liabilities on your balance sheet represent what your business owes to others. This includes loans, accounts payable, and accrued expenses.

The repayment of borrowed funds in itself is generally not a tax-deductible expense for a company. Instead, the only part of paying back debt that can be recognized as an expense is the interest! Principle payments are instead recorded directly as a lowering of the amount owed to the lender.

Debt is one of the main reasons that your company could be profitable but still face cash flow issues.

If your business is heavily leveraged, debt repayments, vendor payments, and other financial obligations could drain your cash, leaving you strapped even when your P&L shows a profit.

How to Make a Rudimentary Cashflow Tracker

Understanding your cash flow requires more than just examining your P&L and balance sheet. A cash flow statement or a simple tracker can help clarify. Here's how to create one:

  1. Identify Cash Inflows: Start by noting down all your sources of cash within a specific period. This includes sales, owner's investment, and loans.
  2. Identify Cash Outflows: Next, record all cash payments. This includes expenses, loan repayments, asset purchases, and owner's draw.
  3. Calculate Net Cash Flow: Subtract your total cash outflows from your total cash inflows. If the result is positive, you have a positive cash flow. If it's negative, you have a cash flow problem.

Remember, this is a simplified version of a cash flow statement, but it can provide a preliminary understanding of your cash situation.

Remember, a profitable P&L doesn't always equate to a healthy cash flow.

The Balance Sheet and Cash Flow statement is equally important in providing a holistic view of your business's financial health. Understanding the interplay between these financial statements is vital to navigating your business's financial landscape and ensuring its continued success!

If you don't feel confident in your understanding of your business's free cash flow, it's important to work with a well-qualified accountant or bookkeeper who can help provide a deeper understanding of your company's financial position.

Working with the right person can help take your business to new heights and ensure that you prevent any future cashflow issues!

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Jeremy Millar
Written by:
Jeremy Millar

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