DO YOU SOMETIMES wonder why your accountant reports that you’ve achieved a healthy profit, but the bank account doesn’t seem to agree? The IRS want their fair share of the money you’ve made, but the cash doesn’t seem to be available to pay them? Isn’t profit meant to reflect the money you have made? If so, where does it all go?
It is a frustration when the two don’t agree, but this is common for most businesses. The main reason is that profit reflects income and expenses — as they are incurred, not as they are paid for. Let me illustrate. Purchasing new store cabinets at a cost of $5,000 will take $5,000 out of your cash flow at the time you pay for it, but when will these cabinets be “used up”? According to most accounting rules, the cabinets will last for several years, so the expense of owning them will be written off against profit over several profit periods, even if you pay for them now. This scenario will make your profit look better than your cash flow.
Likewise, if you sell an item of inventory and the customer doesn’t pay you until the next financial period, your cash flow will suffer in the short term, but your profit will reflect the sale. Why is that? If the item has left your inventory (which it will when the customer takes it), then you will need to account for that — and the only way is to show the sale, even if you haven’t been paid yet. Imagine a scenario where all your inventory is sold, but no one has paid you for any of it in this accounting period. You will have no inventory, but you will also have no sales if you don’t account for the sales in this period. You will have effectively “lost” all the inventory.
Fortunately, most stores get paid in cash, but most store owners have terms extended by their vendors, and this is another example. The inventory you have purchased from a supplier may be included in this financial period as product you own, but you also need to account for the fact you haven’t paid for it if the vendor gives you generous terms. This will show as a cost of inventory in this accounting period, even though you may not see the physical cash get handed over until a later accounting period.
So, in summary, profit reflects the expenses and income attributed to the period in which they relate. Whether you physically pay for those expenses or receive payment for those sales in the same period is a separate matter and is reflected in your cash flow. Ultimately, you should always be able to reconcile your cash flow back to your profit (and your CPA can help with that).