One of the great mysteries in business is why profit isn’t cash. Well, it’s not really a mystery – profit is more like an abstraction that requires further interpretation to fully understand its meaning. We can all agree that creating profit is a good thing and that negative profit (loss) is a bad thing. However, the mind games begin when there is profit but no money in the checking account. And why don’t you go out of business when your profit and loss statements keep showing negative profit? The answer is simple: profit isn’t cash. Hmmm … perhaps it is a mystery after all.
The most important fact to remember about profit is that it has no connection to how much cash is in the bank. For example, you ring up a sale that’s paid for with a gift card. Your Profit & Loss Statement shows the sale, but the cash from the gift card purchase may be long gone. If you enter an invoice for $5,000, your Profit & Loss Statement shows the sale and resulting net profit, but there isn’t any cash until the invoice is paid. When you make a loan payment, only the interest portion of the payment appears on your Profit & Loss Statement while the principle portion of the transaction occurs on the Balance Sheet. In this case, a portion of profit was used to pay principle. [Read more...]