How a Profitable Business Can Run Short of Cash: A Worked Example
The income statement reports a profit of 4,000. The bank balance still falls by 1,500. Both can be correct. Profit measures recognised income and expenses; cash also reflects collection, payment, investment and financing timing.
Work through this original fictional example before deciding that either report must be wrong. All amounts use one currency. Assume no tax, foreign-exchange effects or transactions beyond those described.
Start with the profit figure
| Item | Amount |
|---|---|
| Revenue | 20,000 |
| Cost of goods sold | (12,000) |
| Other operating expenses, paid in cash | (3,000) |
| Depreciation | (1,000) |
| Profit | 4,000 |
Revenue of 20,000 does not tell us how much customers paid during the period. Likewise, cost of goods sold of 12,000 is not automatically the amount paid to suppliers.
Now add the operating-balance movements
Assume trade receivables increased by 7,000, inventory increased by 2,000 and trade payables increased by 3,000. These movements relate only to the operating transactions in this example.
| Adjustment | Amount | Reason |
|---|---|---|
| Profit | 4,000 | Starting accrual result |
| Add depreciation | 1,000 | It reduced profit without a current-period cash payment in this example |
| Subtract increase in receivables | (7,000) | Recognised sales exceeded collections |
| Subtract increase in inventory | (2,000) | Purchases exceeded the cost of inventory sold |
| Add increase in trade payables | 3,000 | Some purchases remain unpaid |
| Net operating cash flow | (1,000) | Operating cash outflow despite positive profit |
This is the indirect approach in a deliberately simple setting. Depreciation is added back to remove a noncash expense from the profit-to-cash reconciliation; it does not generate a new cash receipt.
Check the same operating cash flow directly
Under the stated assumptions, customers paid 20,000 − 7,000 = 13,000. Inventory purchases were 12,000 + 2,000 = 14,000. Since trade payables increased by 3,000, supplier payments were 11,000. Other operating cash payments were 3,000.
Operating cash flow is therefore 13,000 − 11,000 − 3,000 = −1,000. The direct and indirect approaches agree. If yours do not, check for omitted movements or assumptions before forcing a balancing number.
Finish the bridge to closing cash
The business also buys equipment for 3,000 cash, receives a 5,000 loan, repays 2,000 of loan principal and pays a 500 owner distribution treated as financing in this example. Opening cash is 2,500.
| Item | Amount |
|---|---|
| Operating cash flow | (1,000) |
| Equipment purchase: investing cash flow | (3,000) |
| Borrowing received | 5,000 |
| Loan principal repaid | (2,000) |
| Owner distribution | (500) |
| Net cash movement | (1,500) |
| Opening cash | 2,500 |
| Closing cash | 1,000 |
The loan receipt is not sales revenue. Principal repayment is not interest expense. The equipment purchase is not automatically an immediate expense. These distinctions explain why the bank movement and profit differ.
What should the reader investigate?
Ask whether the receivables are collectible, whether the inventory increase was planned and whether supplier payments can be met. Consider the timing of the next collections and payments, not just the closing balance.
A negative operating cash flow in one period does not, on its own, establish business failure. It may reflect growth, timing, poor collections or another cause. Repeated shortfalls require an explanation supported by records and a realistic cash plan.
Try a changed assumption
If receivables had increased by 3,000 instead of 7,000, with everything else unchanged, operating cash flow would be 3,000 rather than −1,000. Profit would remain 4,000 in this model. Enter the two cases in the indirect operating cash-flow tool, then use the cash-flow bridge calculator to check closing cash.
IAS 7 describes operating, investing and financing categories and the direct and indirect presentation of operating cash flows. Actual classification and disclosure requirements need to be checked for the applicable framework and facts; this example is not a complete compliant statement.
