Revenue, profit and cash are different
“How can a profitable company go bankrupt?”
This is the idea that makes the cash flow statement necessary, and it's behind half of all accounting interview questions.
Profit follows when things are earned and used up. Cash follows when money actually moves. The two drift apart all the time.
Accrual accounting in one paragraph
Companies record revenue when they earn it, not when they're paid. Deliver an order in December, get paid in January: the revenue is December's, and until the cash arrives the customer's IOU sits on the balance sheet as accounts receivable.
Costs work the same way. A machine that lasts five years isn't charged to profit all at once: its cost is spread out as depreciation. But the cash leaves on the day you buy it.
- 1Net income = sales $1,000 − expenses $700 − depreciation $100 = $200.
- 2Change in cash = sales collected $1,000 − expenses paid $700 − machine $500 = −$200.
- 3Gap = $200 − (−$200) = $400: the part of the $500 machine not yet charged to profit.
Predict it: up, down, or the same?
Prepaid subscriptions run the other way: the cash arrives first, and the revenue is earned month by month. Until then it's deferred revenue, a liability.
Say it like this
A company can be profitable and still run out of cash because profit and cash are recorded at different times. Revenue counts when it's earned even if customers haven't paid, and big purchases like equipment hit cash immediately but reach the income statement only gradually as depreciation. If customers pay slowly or the company invests heavily, cash can run out even while the income statement shows a profit.
Traps to avoid
- ✕Saying revenue is recorded when cash arrives. Under accrual accounting, it's when it's earned.
- ✕Expensing a long-lived machine all at once on the income statement.
- ✕Assuming more sales always means more cash. Fast growth often eats cash through receivables and inventory.
What they'll ask next
›What's accounts receivable?
Money customers owe for things already delivered. It's an asset until they pay.
›Can a company have cash but no profit?
Yes: taking a big upfront payment for future work, or raising a loan, brings cash in without any profit.
›Where do you see the gap between profit and cash?
On the cash flow statement, which starts from net income and adjusts for non-cash items and timing differences.
Check yourself
A company delivers a $1,000 order in December and the customer pays in January. When is the revenue recorded?