CAT / FIA FFA Syllabus F. Preparing Basic Financial Statements - Differences between profit and cash flow - Notes ^{1 / 5}

Control cash flow

A business may appear profitable on its statement of profit or loss, however if its cash outflow exceeds its cash inflow over a prolonged period then it will not survive. 

Readers of a company's financial statements might also be misled by a reported profit figure.

1. Shareholders might believe that if a company makes a profit after tax, then this is the amount which it could afford to pay as a dividend.

2. Employees might believe that if a company makes profits, it can afford to pay higher wages next year.

3. Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due.

Indeed, a business must generate sufficient cash from its operations to reward the various stakeholders e.g., shareholders and lenders.

An expanding company might have negative operating cash flow as it builds up the level of its inventories and receivables in line with the increased turnover.

However, an increase in working capital without an increase in turnover might indicate operational inefficiencies and will lead to liquidity problems.