Profit does not equal cash?

Question

My friend is looking to buy an existing established business, we have looked over the P&L for the last two financial years. I told her that the net profit doesn't necessarily mean the cash she will have at the end of the year. I couldn't think of anyway to make this clearer for her to understand or any examples to prove it. Please could someone help me, help her understand this?

Answer 1

See if you can show her that while a business can be shown to be profitable, it may be that the profit is in the form of non-liquid assets or stock - you may be holding €10,000 in stock which you own outright, but could owe the bank €7000 in the form of an overdraft, so technically you've got a nett profit of €3000, but no cash to show for it, and demands on your cashflow to make interest and repayments on the overdraft, which could land you in trouble straight away.

Answer 2

Most businesses have debtors and creditors (debtors are people that owe you money and creditors are the ones you owe money to). If all of the debtors were to pay up to date in one go then the company would see that profit. This is never going to happen as the debtors will always be there and money will always be owed throughout the life of the business. However as long as the business continues to make a profit then some real money will be gained and the owner/director can draw from this or pay themselves dividends.
The rest of the companies profits will lie in "assets" which, when sold, would realise more cash for the business.
Hope that kind of explains it.

Answer 3

There are a couple of reasons this is true, from an accounting standpoint.

First is accounts receivables. You can book sales that you haven't received the payment for, and you are profitable even though you don't yet have the cash payment.

Also, there are non-cash items, such as depreciation that are deducted from your earnings that will cause your cash and your net income to differ.

Answer 4

I agree with Rachael, the P&L only tells part of the story, ie %age mark ups and margins. The key document is the balance sheet which will show the business's liabilities (creditors) and who owes it money (debtors). Do the overall assets exceed the overall liabilities? If not, it may be insolvent. How much cash is there on hand and could it meet all the liabilities should all the creditors want paying tomorrow?
What is the level of drawings - could your friend live on these? And what tangible assets are there?

Answer 5

Yes you are correct your profit means that it is not the cash you will have at the end of the year, as (gordon brown) will take some off you.

But the best people to talk to I suppose is Finicial Advisors or Accountants

Answer 6

Profit is the amount your company takes in after expenses. If the business is generating a positive cash flow e.g. making a profit, then i dont see what the problem is..

Answer 7

in accounting there is assets and liabilities. and a picture is worth a thousand words. try to show her the assets and liabilities "T".

oh, yes you are correct in that a business could be profitable which may not show up in cash but liquid assets which is equity.

Answer 8

...it's like when you leave your profit with your friend...you have a profit somewhere, but it's not in your pocket to spend it and make it grow!!

Answer 9

well theres the opportunity cost - she would have made money had she been doing something else.

and re-investment for next years growth.

and that profit has to be assigned between shareholders.

Answer 10

She'll find out soon enough on her own I suppose.