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The Difference Between Cash Flow and Profits
By Jordan B. Zimbelman
Balancing your company’s books is not like balancing your company’s checkbook.
You balance your checkbook using the cash-basis accounting method, which is simply totaling all the deposits, subtracting the payments, and — voilà! — that’s how much money you have in the checking account.
But you can’t report company books balanced that way (which measures cash flow) to either your bank or the IRS. According to generally accepted accounting principles (GAAP), you get a truer picture of your profit with the accrual accounting method.
As a manager, you must understand why profit doesn’t equal cash flow. Both measures, while very different, are important to your financial health.
Accrual Accounting
There are a couple problems with using cash flow to measure your company’s financial performance. Both have to do with the timing of economic events. Consider the following:
- Payment doesn’t always occur at the same time goods and services are provided.
- Revenues and expenses don’t occur at the same time.
Cash flow is, by nature, very volatile. The goal of accrual accounting is to remove some of that volatility so that your financial performance doesn’t depend on when you look at your books.
For example, when a trade contractor finishes his work he mails you an invoice. At that point in time you owe him money. The cash-basis accounting method inaccurately claims that you haven’t incurred an expense because you haven’t paid him yet.
As another example, some builders require deposits from their customers upfront before construction begins. Under the cash-basis method, if you examined your books just after receiving this deposit, it would appear that you’ve turned a huge profit (because you’ve recorded the revenue without any accompanying expenses).
Accrual accounting corrects for these timing issues in two important ways:
- First, revenues are recorded when they are earned, not when payment is received.
- Second, expenses are recorded at the same time as the revenue they help generate.
In the home building business, this means waiting to record revenue and expenses until construction is finished and the home is sold. Expenses that cannot be matched to a specific home, such as advertising, are recorded as soon as they are incurred.
Equity vs. Cash
When you turn a profit, it adds to the equity portion of your balance sheet. Equity is the amount of investment you have in the business. But profit isn’t always cash. To keep your books balanced, the accrual method adds several accounts to your balance sheet:
Payables and Receivables. Say you finish construction on a pre-sold home, but haven’t received payment yet. Because you have earned the revenue, your equity has increased. But there hasn’t been any increase in cash, so what asset does that equity refer to?
To maintain balance, the price of the home is added to a placeholder asset called accounts receivable. When you receive payment, you shift the price of the home out of accounts receivable and into the cash account.
Similarly, when you expense something that has yet to be paid for, equity has decreased without a corresponding decrease in cash. Accounts payable keep your books in balance between expense recognition and payment.
Inventory. You incur many costs and expenses during construction of a home. But they are not recognized on your income statement until closing. How do your books stay balanced with a decrease in cash but not a corresponding decrease in equity?
The costs and expenses are added to the placeholder asset inventory, which offsets the decrease in cash. The inventory is written off when the house is closed.
Liabilities. When a customer deposits cash with you before the home is finished, there is no increase in your equity because you haven’t earned that revenue. To keep your books balanced, the deposit is classified as a liability.
In general, liabilities refer to the amount of borrowed money invested in your business. Although borrowed money increases your cash flow — and you are free to purchase anything you want with it — it is certainly not profit.
Maximizing Your Profit
The goal of your business is to earn you cash. The best measure of this goal is profit because profit takes into account the cash that belongs to you and the cash that belongs to someone else.
For example, part of your profit consists of accounts receivable. Although accounts receivable aren’t cash, they increase your wealth because you have gained the legal right to receive cash in the future.
Moreover, using only cash flow to measure financial performance is inaccurate because it doesn’t take into account investment. Investing your cash in fixed assets doesn’t decrease your wealth, because those assets can be sold for cash in the future.
For example, construction costs and expenses don’t decrease your wealth. Assuming you haven’t made a poor business decision, they should be fully recouped when the house closes. Accrual accounting correctly recognizes these costs and expenses as an investment in inventory.
Profit vs. Owner Compensation
The profit of your business is not the same as your compensation. When you compensate yourself, you take money out of the business and put it in your pocket. That money in your pocket doesn’t bring you any return.
Remember that equity (whether it’s cash, receivables, inventory or something else) is your investment in the business. An investment is putting cash away today for profit in the future. When you compensate yourself, you reduce your equity and are trading larger profits in the future for profits today.
Determining how much to compensate yourself depends on your personal financial situation. Unless you have other, more lucrative business opportunities, you should leave excess cash in the business where it will bring you a return.
Reserving Enough Cash
Although profit is a better measure of financial performance, it’s still very important to monitor cash flow. When your bills come due, you won’t be able to pay for them with accounts receivable or inventory.
The size of your cash reserves determines the risk level of your business. Fixed expenses like loan interest must be paid or you’ll go bankrupt. Maintaining adequate liquidity is one of the most important aspects of financial management.
It’s often tempting to let your cash reserves get too low, because fixed assets offer a higher return on investment. Under accrual accounting, investments are capitalized and therefore show no effect on your bottom line. But profit means nothing if you go out of business to obtain it.
Jordan B. Zimbelman is a graduate student in finance at Kansas State University. He is working with NAHB’s Business Management Department as an intern throughout this summer. For more information, e-mail Zimbelman, or call him at 800-368-5242 x8498.
Additional Resources
- Visit the Accounting and Financial Management section of www.nahb.org/biztools. From accounting methods to profit equations to tax strategies, you’ll find a variety of tools — including NAHB's Chart of Accounts — to manage the financial aspects of your business.
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 How do your profits compare to other home builders’ profits? Find out by reading the "Cost of Doing Business Study, 2004 Edition," available through BuilderBooks.com. This study gives home builders a rare glimpse at other builders’ books by providing data about profitability, cost of sales and expenses from hundreds of home builders across the country. Find out how your home building business measures up against the competition with this valuable study that analyzes several categories (volume, operation type and land costs vs. no land costs) to help builders fine-tune comparisons between study results and their companies. Order it online, or call BuilderBooks.com at 800-223-2665.
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