Cash vs profit: why profitable firms run out of money

Ask most people whether a profitable business can run out of money and they will say no. In accounting, the answer is yes. Understanding why separates a confident IGCSE Accounting student from one who only memorises layouts.

The idea appears across the syllabus: in the income statement, the statement of financial position, ratio analysis and the written interpretation questions where the higher marks are.

Profit and cash are not the same thing

Profit is what is left after you subtract expenses from income for a period. Cash is the money actually in the bank and the till. They move for different reasons and at different times.

Imagine a business sells goods for RM10,000 on credit in December. The sale counts towards December’s profit immediately, because the business has earned it.

But the cash might not arrive until February, when the customer pays. For two months the business is more profitable but no richer in cash.

Everyday language treats “making money” and “having money” as the same. Accounting separates them on purpose. The accruals concept says we record income and expenses in the period they are earned or incurred, not when the cash moves.

Where the gap comes from

Several everyday events push profit and cash apart:

• Credit sales: profit is recorded when the sale is made, but cash arrives later.
• Credit purchases: an expense reduces profit now, but cash leaves later when you pay the supplier.
• Buying non-current assets: paying RM40,000 for a vehicle takes cash out immediately, but only a portion (depreciation) is charged against profit each year.
• Owner’s drawings: taking money out reduces cash but is not an expense, so it does not reduce profit.
• Loan repayments: repaying the capital part of a loan drains cash but is not an expense. Only the interest touches the income statement.
• Inventory build-up: buying more goods than you sell ties up cash in the storeroom. Reported profit does not change until those goods are sold.

Some of these hit profit but not cash, some hit cash but not profit, and some hit both at different times.

A short worked illustration (hypothetical figures)

These figures are invented to show the mechanism. A small trader starts the month with RM5,000 in the bank. During the month:

• She sells goods for RM12,000, all on credit. Customers will pay next month.
• The goods she sold cost RM7,000, which she had already paid for earlier.
• She pays RM2,000 in wages and RM1,000 in rent.
• She buys a second-hand van for RM8,000 in cash, and charges RM200 depreciation for the month.
• She takes RM1,500 in drawings.

Her profit looks healthy. Sales of RM12,000 less cost of sales of RM7,000 gives a gross profit of RM5,000. Take off wages RM2,000, rent RM1,000 and depreciation RM200, and net profit is RM1,800.

Now trace the cash. She started with RM5,000. No cash came in, because every sale was on credit.

Cash went out for wages (RM2,000), rent (RM1,000), the van (RM8,000) and drawings (RM1,500), a total of RM12,500. Her closing balance is RM5,000 - RM12,500 = minus RM7,500.

She is RM1,800 in profit and heavily overdrawn at the same time. The van and the drawings emptied the bank without reducing profit in full, and the RM12,000 of sales raised profit but brought in no cash.

Why it matters in the real accounts

IGCSE Accounting asks students to prepare an income statement, which shows profit. It also asks them to think about liquidity, which is whether a business can pay its short-term debts. A business can show a healthy profit and still fail because it has no cash for wages or suppliers.

This is often called overtrading: growing sales faster than the cash coming in can support. Spotting it earns the higher marks in analysis questions.

The two main statements also connect here. Profit sits in the income statement.

The effects of a cash squeeze show in the statement of financial position instead: a falling bank balance, rising trade payables and growing inventory. A student who can say “this business is profitable but its liquidity is getting worse” is reading the accounts as an examiner wants.

A common confusion to clear up

Many students assume that if profit rises, cash will follow. Sometimes it does, but not always, and not on time. A profitable business can stay short of cash if it keeps giving customers credit.

The same happens if it keeps buying assets or paying out drawings faster than customers pay. “Eventually” does not pay this week’s wages.

A second confusion is depreciation. It reduces profit, so students sometimes think it reduces cash too. It does not.

Depreciation is a non-cash expense, because the cash left when the asset was bought. This is the most common place where profit and cash get muddled.

How to lock the idea in

Take any small worked example. Next to each transaction, write two columns: “effect on profit” and “effect on cash”.

You will see that many transactions affect one column but not the other, or affect them at different times. Try it on the illustration above.

If your child can explain why a profitable business might struggle to pay its bills, they have understood one of the most useful ideas in the syllabus. To practise the recording behind it, try the double-entry trainer.

If profit versus cash still feels slippery, one of our teachers can build it up step by step with worked examples at your child’s pace. See our Year 11 exam prep page or book a trial class.