Accounting Profit vs. Cash Flow

Anonymous
timer Asked: Aug 14th, 2014
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Question Description

A firm's profit does not necessarily equal its cash flow. Explain why using at least 2 Generally Accepted Accounting Principles (GAAP) to support your answer. Also discuss if earning a profit or generating cash flow is more important for a firm.

Tutor Answer

Furious
School: Rice University

Profit is gross income less all expenses. However, the profit may not be present in the form of cash with a company as some amounts will be due from the customers in the form of bills receivables. This is because we always make statements as on a particular date, usually the annual closing. Hence, the saying a sale is not complete till the money is received.

It is important to note the distinction between being profitable and having positive cash flow transactions: just because a company is bringing in cash does not mean it is making a profit (and vice versa). 

For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other. 

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Anonymous
Excellent job

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