The 12-Week MBA Chapter 6: Cash Flow Basics - Profit Is Not Cash

Here is a sentence that will surprise exactly nobody who has ever checked their bank account after payday: just because you earned money does not mean you have money. Companies work the same way.

This is post 8 in my 12-Week MBA retelling series.

Profit and Cash Are Not the Same Thing

The authors open this chapter with a statement that sounds obvious once you hear it but trips up a lot of smart people. Profitability is when a company sells things for more than they cost. Bankruptcy is when a company runs out of cash and cannot pay its bills. Notice how those two definitions have nothing to do with each other.

A company can be profitable on paper and still run out of cash. A company can have plenty of cash and still be losing money. Profit and cash flow live in different worlds, and the thing that separates them is timing.

When you buy something with a credit card and pay the bill six weeks later, you have pushed profit and cash flow apart. The store made a sale. But it did not get your actual money for another month and a half. Scale that up to a company like Boeing, where a jet takes years to build and payments come in chunks that might not line up with when expenses happen, and you can see how messy this gets.

The Food Truck Example

The authors keep using their food truck example, and it works well here. Imagine you start a food truck. You put in $25,000 of your own money. A bank loans you another $25,000. Those are two flows of cash into the company, but they are not sales. They are not profit. They will never appear on your profit and loss statement.

Then you buy $40,000 worth of equipment: the truck, cooking gear, cutting boards, all of it. That cash leaves your bank account immediately, but that purchase does not show up as an expense on your P&L either. It shows up on the balance sheet as an asset that slowly loses value over time through depreciation.

So right from day one, big chunks of cash are moving around that have nothing to do with selling sandwiches.

Three Buckets of Cash Flow

This is why companies use a separate report called the cash flow statement. It tracks every dollar moving in and out, grouped into three categories.

Cash flow from financing is money coming in from investors and going back out to them. Taking a loan? That is an inflow. Paying back that loan? Outflow. Selling shares to new investors? Inflow. Paying dividends? Outflow.

Cash flow from investing is about buying and selling long-term assets. You bought a new oven for the food truck? Outflow. You sold the old truck because you are upgrading to a restaurant? Inflow.

Cash flow from operations is the day-to-day stuff. Cash coming in from customers. Cash going out to suppliers and employees. This is the one most people think of when they hear “cash flow.”

For a simple business like a food truck, where customers pay right away and suppliers want their money immediately, operating cash flow and profit might be pretty close to the same number. Customers hand you cash or swipe a card. You pay for bread, cheese, and tomatoes the same week. Everything lines up.

When Things Get Lumpy

But now think about Boeing. They negotiate an up-front payment from an airline, then spend years building the jet, then get a second payment on delivery. During all those years, they are paying employees and buying parts. If Boeing just tracked raw cash in and out, some quarters would look amazing because a bunch of customer payments happened to land at the same time. Other quarters would look terrible because nothing came in.

Those wild swings make it nearly impossible to tell what is actually going on. Did we lose money this quarter because the business is failing, or just because no customer payments were due? Did we have a great quarter because we are doing well, or because a bunch of prepayments landed at the same time?

The lumpiness hides the real story. And if it confuses the managers running the company, imagine how confusing it is for investors trying to decide if this company is worth their money.

Accrual Accounting to the Rescue

This is where accrual accounting comes in. Instead of recording sales when cash arrives, you record them when you deliver the product. Instead of recording expenses when you pay for something, you record them when they are connected to a specific sale.

Boeing records a sale when it hands the keys to a jet to an airline. All the expenses that went into building that specific jet get recorded at the same time. The fact that the airline might have prepaid two years ago or that some supplier bills are not due until next month does not matter for the P&L. What matters is matching the sale to its costs.

This smooths everything out. Instead of wild swings quarter to quarter, you get a clearer picture of whether the company is actually buying low and selling high. That is the whole point of the profit and loss statement: to show how well the company creates value for customers while keeping costs under control.

The Danger of Looking at One Report

But here is the catch. By smoothing out the bumps, the P&L hides something important. The company still needs actual cash to pay its bills. You cannot pay your employees with “recognized revenue.” You cannot hand your landlord an accrued expense and call it even. Cash is what keeps the lights on.

This is why the authors keep saying that no single financial statement tells the full story. You need all three: the P&L, the cash flow statement, and the balance sheet. Individually, each one can be dangerously misleading. Together, they give you the full picture.

When the Perfect Storm Hits

Sometimes companies face a moment when everything goes wrong at once. Suppliers need to be paid, no customer payments are coming in, a big loan payment is due, and new equipment needs to be purchased. If the underlying business is solid, a bank will usually step in with a short-term bridge loan to cover the gap. That is how the partnership between business and finance is supposed to work.

But during a financial crisis, banks might stop lending to everyone. That is exactly what happened in 2008. Banks lost confidence in each other because of bad mortgage investments and stopped lending to one another. Since banks need to borrow from each other to fund short-term business loans, companies that had nothing to do with housing or mortgages suddenly could not get the bridge loans they needed.

Good companies with strong business models went under simply because they happened to be in industries with lumpy cash flows. They were profitable. Their products were solid. They just could not get cash when they needed it because the entire financial system froze.

Why Investors Care About Predictability

This brings us back to something we have been building toward across multiple chapters. Investors, all else being equal, prefer companies with regular, frequent, and predictable cash flows. Not because those companies are necessarily better at what they do, but because they are less likely to get caught in a crisis they cannot control.

A company that collects cash from customers every week is safer than one that gets paid once a year. Not because the product is better, but because the cash flow pattern gives it more room to survive bad luck.

This is one of those ideas that sounds simple but has huge consequences. Two companies might have the exact same profit margins and growth rates. But the one with smoother cash flows is worth more to investors, because there is less chance that a temporary cash crunch will destroy an otherwise healthy business.

Key Takeaway

Profit is an opinion. Cash is a fact. A company can look great on the P&L statement and still go bankrupt because it ran out of actual money. The cash flow statement exists to track what the P&L cannot: where the real money went. It breaks cash movements into three buckets (financing, investing, and operations) and together with the P&L and balance sheet, tells the complete story of a company’s financial health. If you only look at one of these reports, you are seeing the world with one eye closed.

Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9

Previous: Chapter 5 - The Balance Sheet Part 2

Next up: Chapter 7 - Cash Flow and Working Capital Part 1 - Why growing companies sometimes go broke.

Part of the 12-Week MBA retelling series