Accounting/Finance?

Question

Can anyone briefly explain of how can a firm be profitable but yet not have sufficient cash to satisfy its creditors? and also, how can a firm that turn a negative profit, have positive cash-flows?

Answer 1

Cash Flow vs Income

It is important to note the distinction between being profitable and having positive cash flow transactions: just because a company is bringing in cash does not mean it is making a profit (and vice versa).

For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other.

Because public companies tend to use accrual accounting, the income statements they release each quarter may not necessarily reflect changes in their cash positions. For example, if a company lands a major contract, this contract would be recognized as revenue (and therefore income), but the company may not yet actually receive the cash from the contract until a later date. While the company may be earning a profit in the eyes of accountants (and paying income taxes on it), the company may, during the quarter, actually end up with less cash than when it started the quarter. Even profitable companies can fail to adequately manage their cash flow, which is why the cash flow statement is important: it helps investors see if a company is having trouble with cash.

Cash Flow Verses Profit

Profit and Cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat broad and only looks at income and expenses over a certain period of time, say a fiscal quarter. Profit is a useful figure for calculating your taxes and reporting to the IRS.

Cash flow, on the other hand, is a more dynamic tool focusing on the day-to-day operations of a business owner. It is concerned with the movement of money in and out of a business. But more importantly, it is concerned with the times at which the movement of the money takes place.

Theoretically even profitable companies can go bankrupt. It would take a lot of negligence and total disregard for cash flow, but it is possible. Consider how the difference between profit and cash flow relate to your business. For example, if your retail business bought a $1000 item and turned around to sell it for $2000, then you have made a $1000 profit. But what if the buyer of the item is slow to pay his or her bill, and six months pass before you collect on the account? Your retail business may still show a profit, but what about the bills it has to pay during that six-month period? You may not have the cash to pay the bills despite the profits you earned on the sale. Furthermore this cash flow gap may cause you to miss other profit opportunities, damage your credit rating, and force you to take out loans and create debt. If this mistake is repeated enough times you may even go bankrupt!

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Answer 2

Profit is determined on the accrual basis - you can have revenue yet not have received the cash yet. I worked for a company once that had plenty of profit on paper, yet all of of customers were dot-coms that couldn't pay their bills. So that company went out of business.

A firm with negative profit could have positive cash flow if they have alot of non-cash expenses (such as amortization or depreciation).

Answer 3

You are talking about two firms one remaining fully invested and the other hoarding cash. The former one is very scientifically run and has profits but no cash hoarding and the latter is hoarding cash and remain less than fully invested due to lack of managerial initiative or lack of opportunities in the industry class.
The second type is usually takeover targets.

Answer 4

When you reach the age of majority in your state (18 for most of the US). Your mom is wrong. If you can legally enter into a contract, you can legally manage your own resources. Keep in mind, however, that there might be some minor changes or differences if your money is held in a trust or if it is based on child support which must be paid until a certain age.