An owner looks at a healthy bank balance in October and hires two people. In April the tax bill arrives, the balance is gone, and the profit and loss says the business made money all along. Another owner sees the account drop by $30,000 in a month and cancels a marketing campaign; the drop was a stock order that will sell over the next quarter at a good margin. Both decisions came from reading one number as if it meant the other.
What profit measures
Revenue earned minus costs incurred in the period, whether or not the cash has moved. An invoice raised in March is March revenue even if it is paid in May. A year's insurance paid in January is spread over twelve months. Equipment bought for $10,000 is expensed over its useful life, not on the day it is bought. Profit is a measure of what the business is worth doing.
What cash measures
Money in minus money out. It includes things profit ignores (loan principal, owner draws, equipment purchases, inventory purchases, tax payments, deposits received) and excludes things profit includes (invoices not yet paid, bills not yet paid, depreciation). Cash is a measure of whether the business can pay Friday's payroll.
Where the gap comes from
| Item | Effect on profit | Effect on cash |
|---|---|---|
| Invoice raised, unpaid | Revenue up | None yet |
| Customer prepays a year | One month of revenue | Full amount in |
| Stock purchase | None until sold | Full amount out |
| Equipment purchase | Depreciation only | Full amount out |
| Loan received | None | In |
| Loan repayment | Interest portion only | Full payment out |
| Owner draw or distribution | None | Out |
| Income tax payment | None (or below the line) | Out |
| Sales tax collected | None | In, then out |
Reading the cash flow statement
The third financial statement reconciles the two. It starts from profit, adds back non-cash charges (depreciation), adjusts for working capital (receivables, payables, inventory, deferred revenue), and then shows investing (equipment) and financing (loans, owner money) separately. A business whose operating cash flow is consistently below its profit is either growing fast (receivables and inventory absorbing cash) or collecting badly. The statement says which.
The four common traps
- Tax money treated as available. Income tax, payroll tax and sales tax collected all sit in the same account as operating cash. A separate tax account, funded monthly, removes the April surprise.
- Growth eating cash. Every extra month of sales on 45-day terms is a month of costs paid before the cash arrives. Profitable growth needs funding; the 13-week forecast shows how much.
- Draws exceeding profit. Owners who take what is in the account, rather than a set amount from profit, hollow the business out invisibly, because draws never appear on the profit and loss.
- Capital purchases mistaken for expenses. The reverse trap: the bank falls, profit does not, the owner panics about a business that is fine.
The monthly check
Put last month's profit next to the change in cash. Explain the difference in five lines or fewer: receivables moved by this much, inventory by that, loans, draws, tax, capex. If it can be explained, both numbers are trustworthy. If it cannot, something is unreconciled. This five-line reconciliation is on the first page of every management pack we send.
The check you can run today: this month's profit, minus the change in your bank balance. Write down what the difference is made of. Whatever you cannot name is the thing to look at.