by Bill Steele

Created on: October 08, 2008   Last Updated: June 15, 2010

Profit is an attempt to measure the value added by the activity of the team of people who make up a business. Accountants attempt to measure this by following some established principles; for example, matching income and expenses in the relevant period, ensuring that the expenses incurred in getting the sale and delivering the product or service are recorded in the same period as the sale itself.

Accountants can obviously record all the transactions undertaken in the period; all the cash coming in and out. But in order to do that matching, some adjustments are required for bills or income which we know is coming, but isn't here yet. Or items which don't involve cash, like depreciation. Depreciation is the way in which accountants allocate the cost of a major asset over the period expected to benefit from that asset. For example, if a business buys a car, which is expected to last for three years, the cost of that car can be split in three and allocated in proportion across the three years. There are more complex ways of doing it, but the intention is the same.

So we can then produce a profit and loss account - the measurement of value added - and a balance sheet, which is intended to be a measure of the net worth of a business. But because we've done so many adjustments based on these principles, many people find it hard to understand. They do understand cash going out and coming in, so the cash flow statement is an attempt to reconcile profit with cash flow. You could say to get back to reality. It is an attempt to answer the question about why so many apparently profitable companies can still go bust because they run out of cash.

The cash flow starts with profits and tries to reverse all those clever adjustments to show something close to total cash flows. Many small businesses are of course run on cash flow only - most proprietors know what cash they have, or is coming in or going out, but many have no idea what profit they are making. That seems relevant only at tax time.

It is important to know both. Of course the business will die without positive cash flow, and that needs to be managed on a daily basis. You don't need an accountant for that - and in fact the "accounting concept" of cash flow is of little use here. Just check your statement or go to the ATM. But the profit is important too, because if you do not make profit you will eventually not have the resources to continue in business. If you are not making profit, you are not adding value, and need to either stop or change the method. If this is what's happening, the sooner you find out about it the better.

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