Why Profitable Companies Still Run Out of Cash: Cash Flow Gap

The results in your company's quarterly financial statement indicate an increase in revenue. The company has adequate revenue margins and has met its sales objectives. Moreover, there are adequate finances for its operations.

However, when evaluating the cash needed to cover payments for materials, salaries, and future operations, the company does not have enough cash on hand. How is it possible for a profitable firm to face problems meeting its financial obligations?

The best thing is to become familiar with the concept of cash flow vs profit. Profitability means a company generates more profit than expenses, while cash flow shows whether the company has enough cash to run its operations.

Understanding the Fundamental Difference Between Cash Flow & Profit

Certainly, there is a straightforward relationship between cash flow and profit. However, they measure separate aspects of financial performance.

Profits are the amount of revenues minus expenses. In accrual-basis accounting, revenues might be recorded even if customers have not paid for goods yet.

Cash flow shows the actual movement of money in and out of the business within a specified period of time.

Take, for example, a manufacturing business whose revenues are $5 million in a quarter. The expenses incurred by the business are $4 million, hence making an accounting profit of $1 million.

Nonetheless, assume that out of these sales, $2 million is yet to be received by the firm. On the other hand, the latter has already paid off most of its supplier invoices.

The company, despite earning a profit, might find itself experiencing a cash shortage.

It is through this illustration that one is able to appreciate the practicality of profit vs cash flow.

Reasons For Cash Flow Problems in Profitable Companies

Having good sales performance and profit margins does not necessarily mean that the company is undergoing cash inflow. There are a number of reasons why cash flow issues arise, despite having high income.

1. Late Payments from Customers

The most common reason behind cash flow difficulties is the timing between revenue recognition and payment.

In many cases, the payment terms between a business and its customers might be 1, 2, or 3 months. Although these sales will add up to the revenue, it might take some time before the cash is received.

However, at the same time, salaries, expenses, and payments have to be made. Thus, as the receivable balance grows, the company requires additional financing.

2. Overworking Working Capital

Working capital is calculated as current assets minus liabilities. It indicates a company's liquidity position.

Nonetheless, even companies with positive working capital can face liquidity problems when it is largely composed of unsold inventories and outstanding receivables.

Consider the case of retailers who stock up on inventories before seasons with high demand for their products. Such inventory stocking operations require immediate payments.

As a result, the more a business grows, the higher its cash demand becomes.

3. Double Payments and Unnecessary Payments to Suppliers

Cash shortages don't always arise because of late collections from customers.

There are other businesses that lose accessible cash due to mistakes in their accounts payable department.

Such mistakes include double payments, wrong prices for supplies, unjustified charges, and lack of discounts.

It is especially challenging to spot such issues in businesses that work with thousands of suppliers and have several ERP systems at the same time.

Even though such issues seem minor, they significantly affect business cash flow when added up together.

4. Unutilized Supplier Credits and Rebates

The company negotiates discounts from suppliers, promotional discounts, rebates, and return credits to save money on purchasing.

Nevertheless, such benefits may not end up being accounted for in the company's books.

The vendor may give a credit note that never gets applied. The rebate agreed upon may never be taken advantage of. Discounts in the contract may not be considered while paying invoices.

The consequence will be lost value that does not go into the company's cash inflows.

Financial Leakage Making Cash Flow Gap Worse

Classical cash flow management is usually oriented at receivables, payment terms, inventories, and financing strategies.

Though these matters are indeed important, one more issue requires analysis. The issue is the amount of cash outflow from the business.

Financial leakage refers to the situation where a company loses its resources due to mistakes in transactions, contracts, or poor financial control.

For instance, a company could make a double payment to its vendor because of small differences in invoice references.

Another case may be a purchase contract where the negotiated price is specified, while invoices still demonstrate a higher figure.

In such a way, the cash flows occur for unnecessary reasons.

However, even when these issues are detected, it takes some effort to get back the funds involved.

Therefore, financial leakage is one more aspect that should be considered in terms of cash flow vs profit analysis.

Improvement of Cash Flow Management By Business

Liquidity problems cannot be addressed merely through increasing revenue or cutting costs. It is important for financial officers to gain better insight into the flow of funds through the company.

Improve Accounts Payable Recovery Audits

The accounts payable recovery audit is conducted to determine instances of double payments, overcharges by suppliers, price differences, and unused credits.

Unlike financial audits that mainly assess accuracy and compliance, recovery audits concentrate on uncovering recoverable amounts.

Where legitimate recoveries lead to refunds or credit balances from suppliers, firms can increase their liquidity without increasing sales.

Monitoring Supplier Contract Compliance

Many supplier contracts involve pricing terms, rebates, discounts, and payment terms, among others.

Nevertheless, all these advantages are not realized until the supplier is compliant with the contract terms.

Compliance with contract audit entails comparing the transactions to the contract terms.

Implement AI-Powered Transaction Analytics

The task of manual review becomes harder as transactions increase.

With AI-fueled analytics, large sets of data can be analyzed for detecting anomalies in payments, duplications in invoices, and discrepancies in procurement data.

Early detection of any anomalies means that possible losses can be detected sooner, before becoming persistent issues.

Continuous monitoring also helps in building better financial controls and effective audits.

Enhance Visibility of Working Capital

Effective cash flow management needs complete knowledge of accounts receivable, inventories, accounts payable, and recoverable vendor balances.

It is essential for finance managers to review the cash conversion cycle, payment cycle, credit balances, and cash requirements.

A combination of the above two will enable organizations to differentiate between liquidity problems and financial leakage.

Why Being Profitable Alone Is Inadequate

An adequately profitable company may be experiencing financial problems if cash is not available when needed.

Profitability alone cannot instantly pay off debts with suppliers if cash flows are not yet realized. Likewise, being highly profitable cannot offset the frequent mistakes in overpayment and failure to get credits back.

This is the reason why financial managers need to consider both the profitability and liquidity of a company rather than thinking that one is the same as the other.

However, what is more important is that they should realize that making cash available is all about safeguarding current funds rather than earning more money.

Final Thoughts

It is important to grasp the difference between cash flow and profit in order to remain financially stable. Profitability is used to evaluate business performance. On the other hand, cash flow is used to determine whether the company has the capacity to pay off its short-term debts and continue operating.

Late payment issues, working capital issues, and financial leakage may all result in liquidity issues.

The Discover Dollar team enables companies to handle avoidable cash leakage via accounts payable recovery audits, contract compliance checks, and transaction management. The credit for it goes to artificial intelligence.

Cash protection from what has been made is often as important for finance executives as creating new profits.

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