Where is the Cash? Since cash is the life blood of a business, it is important to understand where the cash went and why the cash balance in the check book is not the same as the net profit/loss of the income statement (P/L statement). Many business owners are confused when they look at their cash balances and compare it to the profit that appear on the P/L. Where is the Cash? They ask. Why am I short in the check book when the financial statement show that I made a profit?
Net Profit for the period is $100,000
Cash in the bank is $45,000
And in some cases, the situation could be reversed-Cash in bank 100,000, Net Profit $45,000
To begin understanding this, let’s go back to the basics of accounting and review three most popular financial statements:
- Profit/Loss Statement (also known as the Income Statement)
- Balance sheet
- Cash flow statement
- Profit/Lost shows the difference between the income less the expenses
- Balance Sheet shows what the business has (assets), what the business owes (liabilities) and the net worth (equity)
- Cash Flow Statements shows the owners how the spent and where they received their money from
- Financing-loans or payments
- Investment-putting money in or taking money out of the business
With this review, and the examples below one will be able to see why the cash in the bank rarely equals the amount of profit or loss that shows on the P/L statement
- Sometimes we generate revenue by selling products/services and they are not paid for at the time of service.
- Sale appears on the income statements as revenue
- Cash does not change
- Company may buy inventory and pay cash for it
- Inventory is not an expense until sold therefore it does not reduce the profit on the income statement, but it DOES reduce the Cash Balance in the check book
- Buy furniture/equipment for the business and pay cash
- Since furniture/equipment is not an expense to the business but an asset, it does not reduce the profit on the income statement, but it DOES reduce the cash in the check book
- Company obtains a loan from the bank
- Increases the cash in the check book but no change in income so there is no change in the profit of the business
- Company makes a payment back to the bank for the loan
- The cash goes DOWN by the amount of the payment, but the profit only gets reduced by the interest part of the loan since the principle part of the loan is not an expense but simply a repayment of the debt.
- Owner takes cash out of the business-called an owners distribution
- Cash will go down in the check book
- No change in the profit of the business since the distribution is not an expense to the company but a return to the owner
- Owner investment into the business is the same situation as the above but acts in the reverse-increase in cash to the business with no change in profit
- Company buys supplies from their vender and does not pay cash but charges it
- The profit will be decrease since the supplies are and operating expense but since it was charged there was no change in the cash balance in the check book
From these examples not everything affects cash at the same time that it affects the income statement and even though it affects cash it may NEVER affect the income statement.
The purpose of the financial statements is to provide information to the owners, so they can better manage their business. Not everything that a business does affects the P/L statements. From the examples above, one can see that many transactions only hit the balance sheet such as principle payments on a loan, distributions or contributions made by or from owners, furniture/equipment purchased, customers charges (account receivable), vender not being paid (account payable) and many more. The items that do not hit the income statement, either increase or decrease the asset, liability or equity accounts of the of the balance sheet and also affect cash, which is a balance sheet account.
To understand why the profit does not equal the cash in the bank, one would need to Reconcillate between the income statement and the balance sheet through the “Cash Flow Statement (CFS)”. Buy doing this the owners will see where and how they spent their cash. The CFS divides the cash transactions into three different categories (as shown above). Operating, Financing, Investing. By looking at this statement, the owner can then evaluate how and why the cash balance in the banks is what it is.
View Neil’s Facebook Live Teaching on “Where is the Cash?” below: