Welcome to Chapter Review: Cash vs. Profit and Business Health!
Hello future accountants! This chapter is crucial because it teaches you how to read the vital signs of a business. We often hear the phrase, "Cash is King," but why does a business sometimes have lots of cash yet still make a loss? And why might a highly profitable business suddenly run out of money?
In this section, we will uncover the difference between cash flow and profitability and see exactly how different business transactions impact the overall health (the profitability and the liquidity) of a company. Don't worry if this seems tricky at first; we will break down the complex ideas into simple, clear steps!
Quick Review: Accounting Fundamentals
Remember that the main goal of financial accounting is to measure performance (Profit) and financial position (Assets, Liabilities, and Capital).
1. The Difference Between Cash and Profit
Cash and Profit are two completely separate ideas. Confusing them is one of the biggest reasons businesses fail!
1.1 What is Profit?
Profit measures the financial success of a business over a specific period (usually a year). It tells us how much money the business earned *after* deducting all the costs and expenses related to those earnings.
Profit is calculated using the Accruals Concept (or Matching Concept). This means we record revenue when it is earned and expenses when they are incurred, regardless of when the cash actually moves.
\(\text{Profit} = \text{Revenue Earned} - \text{Expenses Incurred}\)
Example: If you sell £100 of goods today on credit, your Profit calculation immediately increases by £100 (Revenue), even if the customer won't pay you for 30 days.
1.2 What is Cash?
Cash (or Cash Flow) measures the actual movement of money in and out of the bank account or cash till over a period.
Cash is recorded only when the money physically changes hands.
Example: If a customer pays an invoice from last month, your Cash Balance increases immediately, but your Profit is unaffected (because the revenue was already recorded last month).
1.3 Analogy: The Pocket Money IOU
Imagine your friend owes you £10 (an IOU). You have "earned" the money (this is like Profit), but you haven't actually received it yet. If your parents give you £5 for chores (Cash sale), you have both earned the money and received the cash.
- Profit is the total amount you are owed and have earned.
- Cash is the actual money in your pocket right now.
Key Takeaway: A business can be highly profitable (lots of IOUs) but run out of cash (empty pockets) if its customers take too long to pay!
2. Understanding Profitability and Liquidity
When we analyze a business's financial statements, we are usually looking at two main indicators of health: Profitability and Liquidity.
2.1 Profitability: The Long-Term Success
Profitability is the measure of a business's ability to generate earnings compared to its expenses. It answers the question: "Is this business model efficient and successful in the long run?"
High profitability means the business is managing its costs well and selling goods or services at a good margin. This usually leads to growth and happy owners (shareholders).
- Increased Profitability comes from increasing sales revenue or decreasing operating costs (e.g., lower wages, cheaper suppliers).
- Decreased Profitability comes from sales falling or costs rising faster than sales.
2.2 Liquidity: The Short-Term Survival
Liquidity is the ability of a business to meet its short-term debts and obligations as they fall due. It answers the question: "Can the business pay its bills next week?"
A business needs good liquidity to pay its suppliers, employees, and rent on time. Liquidity involves comparing a company's Current Assets (things that can be turned into cash quickly, like Inventory or Receivables) to its Current Liabilities (debts due within one year).
Memory Trick:
Lick-uidity -> Think LICKING your debts (paying them off quickly).
Key Takeaway: Profitability is about making money; Liquidity is about having money when you need it.
3. The Effect of Transactions on Profitability and Liquidity
Every transaction a business makes will affect at least two accounts (the dual effect concept). We must analyze if the transaction impacts the income statement (Profitability) or the balance sheet (Liquidity), or both.
3.1 Transactions Affecting Profitability ONLY
These transactions often involve accruals or non-cash charges where the cash movement happened much earlier or will happen much later.
- Recognising Depreciation: When we record the wear-and-tear of a non-current asset.
- Effect on Profitability: Decreases (Depreciation is an expense).
- Effect on Liquidity: None (No cash movement today).
- Writing off a Bad Debt: Determining that a customer will never pay the money they owe.
- Effect on Profitability: Decreases (Expense increases).
- Effect on Liquidity: None (The cash was never expected, and no cash is moving now).
3.2 Transactions Affecting Liquidity ONLY (or primarily)
These transactions involve changing the composition of assets or settling existing liabilities without changing the revenue or expense figures for the period.
- Paying off a Supplier (Creditor): Paying money owed for goods already purchased.
- Effect on Profitability: None (The cost of goods was already recorded).
- Effect on Liquidity: Decreases Cash (Asset) AND Decreases Current Liabilities (Improves the ratio of CA to CL).
- Buying Inventory for Cash: Using cash to buy stock.
- Effect on Profitability: None (Inventory is an asset until it is sold).
- Effect on Liquidity: None/Minimal Change (Cash decreases, but Inventory—a Current Asset—increases. The composition of current assets changes, but the total usually remains the same).
3.3 Transactions Affecting BOTH Profitability and Liquidity
These are typically cash sales or the immediate payment of operational expenses.
- Paying Rent or Wages in Cash:
- Effect on Profitability: Decreases (Expense increases).
- Effect on Liquidity: Decreases (Cash decreases).
- Cash Sales of Goods:
- Effect on Profitability: Increases (Revenue increases).
- Effect on Liquidity: Increases (Cash increases).
Common Mistake to Avoid!
Students often assume that all money received is profit. It is not! Receiving a bank loan or receiving payment from a customer who owed you money (a debtor) increases your cash, but it does not increase your profit.
Quick Review Box: P & L Impact Summary
Credit Sales: P up, L increases later (when cash is received).
Cash Expenses (e.g., Wages): P down, L down.
Loan Received: P unaffected, L up (Cash increases).
Buying Asset on Credit: P unaffected, L potentially worse (Current Liability increases).
4. The Importance of Balanced Health
For a business to survive and succeed, it needs both high profitability and strong liquidity.
Did you know? Many start-up technology companies operate at a loss (low profitability) for years because they are investing heavily in future growth. They survive only because they have strong liquidity, raised by investors who believe in their long-term profit potential!
4.1 The Profit Trap
A business might look great on the Income Statement (high profit) but fail because it cannot collect its debts quickly enough. They might have profit but no physical money to pay the electricity bill.
4.2 The Cash Trap
A business might have excellent liquidity (lots of cash in the bank) because they just sold off a Non-Current Asset (like a factory). However, if their day-to-day sales are losing money, they will eventually run out of cash once the high expenses eat away at the fund. The business is fundamentally unprofitable.
The interpretation, analysis, and communication of financial information rely on understanding these differences. When you evaluate a business, you must look at both the Income Statement (Profitability) and the Statement of Financial Position (Liquidity).
Final Key Takeaway:
A healthy business is both profitable (earns more than it spends over time) and liquid (can pay its immediate bills).