Cash Is Not Profit
Every founder learns three words the hard way, and I would rather you learned them from a lemonade stand. Here they are: cash is not profit.
I teach accounting at Pepperdine, and I open every term the same way. Profitable companies go bankrupt every day. Bankrupt does not mean you are not profitable. It means you ran out of cash. Unprofitable companies, meanwhile, can be worth billions. The two numbers are related, but they are not the same number, and the difference is where most new businesses get into trouble.
The lemonade stand
Say you are ten years old and you want to sell lemonade on a sunny Saturday. You have no money, so you borrow $15 from Mom for lemons, sweetener and cups. Your supplies cost $10. You have a good day and sell 30 cups at $1 each, with nothing left over.
How did the business do? Easy: $30 in sales, $10 in costs, $20 of profit. Not a bad start to a citrus empire.
But that $20 does not tell you about the money you borrowed from Mom. There is no place for a loan next to your sales. So take a second look, and call it cash. Before you talked to Mom you had nothing. After you talked to Mom you had $15. At the end of the day you have that $15 plus the $20 you made, which is $35 in the cash box.
Your profit is $20. Your cash is $35. Same business, same day, two different numbers, and both are right. The loan never shows up in profit, because a loan is not a sale. It shows up in cash, because it is sitting in the box.
Why the numbers drift apart
The lemonade stand is the simplest case. In a real business the gap between profit and cash opens up for four reasons, and your projections need all four.
- Loans and investment. Money that comes in from a lender or an investor is cash, not revenue. Money you pay back is cash out, but only the interest is an expense on the P&L.
- Receivables. You make a sale in March and the customer pays in May. Profit records the sale in March. Cash arrives in May. Think of every receivable as a zero-interest loan you are making to your customer.
- Payables. The mirror image. You get the invoice now and pay in 30 days. The expense hits profit today; the cash leaves next month.
- Equipment. Buy a $70,000 machine that will last seven years and the cash leaves on day one, but the P&L spreads the cost over seven years as depreciation, $10,000 a year. Your profit looks fine the month you buy it. Your bank account does not.
Add inventory to that list for anyone who sells a physical product: you pay for the stock months before you sell it, and the cost only reaches the P&L when the sale happens.
How profitable companies run out of cash
Here is the pattern I have watched a hundred times. A company lands a big contract, so it hires and buys inventory to deliver it. The contract pays net 60. For two months the P&L shows a healthy profit and the bank account drains, because the money for the hires and the inventory went out before a dollar came in. If there is no cushion, the company misses payroll while technically profitable.
That is why the Cash Flow Statement exists. Its whole job is to translate the profit at the top into the cash at the bottom. Net income comes in from the P&L, the statement adds back the depreciation that was never actually paid to anyone, subtracts the receivables you are still waiting on, adds back the payables you have not paid yet, takes out the equipment and inventory you bought, and adds the loans and investment that came in. What is left is what is in the bank.
What to do about it
Two numbers matter more than profit until your cash stops being a concern.
- Burn rate is how much cash you go through in a month, not counting any investment you received. Start of month minus end of month, averaged over a stretch where the business looked roughly the way it does now.
- Runway is your cash divided by your burn rate, rounded down. If you have $1,144,500 in the bank and burn $294,167 a month, you have three months, and raising money takes longer than that.
A set of projections can show losses for a year, or three, and still be a plan an investor will fund. What it cannot show is a month where cash goes below zero. When it does, you change something in the plan until it does not.
That is the whole lesson. Profit is an opinion about how the business did. Cash is a fact about whether it can keep going. Watch both, but never confuse them.
The free Accounting 101 Boot Camp walks through the lemonade stand with the actual statements, and EZ Numbers builds the cash flow for your own business, month by month, so you see the gap before it bites.