Why a profitable month can still bounce a cheque

Profit and cash flow are both true statements about the same month, and they routinely disagree by a wide margin. That is not an error in either one. They are answering different questions.

Profit answers: over this period, was the value of what we sold greater than the cost of producing and selling it? It is computed from the point at which a sale is earned and a cost is incurred, which is usually the invoice date rather than the payment date. Cash flow answers a narrower and more brutal question: over this period, did more money enter the bank account than left it?

A business can answer yes to the first and no to the second for months on end, which is the situation where the owner is looking at a healthy profit-and-loss statement while wondering whether the salary transfer will go through. The reverse also happens: a month with a large customer advance and no deliveries shows money piling up in the bank against a loss on the P&L. Neither statement is lying. Reading only one of them is what causes the surprise, and most small businesses read only the one their accountant hands them, which is the P&L.

The largest source of divergence is that the accounting entry and the bank movement happen on different dates, sometimes months apart.

A credit sale is revenue on the day the invoice is raised. The money arrives when the customer pays, which in a business selling to other businesses is frequently thirty to sixty days later, and sometimes longer. Every rupee of that gap is profit that exists on paper and not in the bank. Grow the business and the gap grows with it, because a larger sales month means a larger amount waiting to be collected. This is the specific reason that fast growth can be more dangerous to cash than flat sales.

Stock works the same way in reverse. Buy inventory in March and the money leaves in March, but the cost only reaches the profit-and-loss statement when the item is sold, which may be June. March therefore shows cash going out with no matching expense, and June shows an expense with no matching payment. Purchases made on credit invert it again: the expense lands now and the money leaves later. None of these are unusual events. They are the ordinary rhythm of trading, and they guarantee that the two numbers will not match.

Beyond timing, three ordinary payments leave the bank account without ever appearing as an expense on the profit-and-loss statement. They are the classic reason a profitable business runs out of money, and they are invisible if the P&L is the only document being read.

Capital purchases. Buy a delivery van or a set of machines and the whole amount leaves the bank at once. The profit-and-loss statement does not record the purchase as an expense at all. It records depreciation, a portion of the cost spread across the years the asset is expected to be used. So the month of purchase shows a large cash outflow and a small expense.

Loan principal repayments. When an equated monthly instalment leaves the account, only the interest portion is an expense. The principal portion is a reduction of a liability, which is a balance-sheet movement. A business repaying a substantial loan can therefore show good profit while a large monthly sum leaves the bank invisibly.

Owner drawings. Money the proprietor or partners take out for personal use is not an expense in any amount. It is a withdrawal against capital. Salary paid to a director on the payroll is an expense; a proprietor taking money out is not.

The two figures can be reconciled, and doing it once by hand is the fastest way to understand your own business. Start with the net profit for the period. Add back depreciation, because it reduced profit without moving any money. Then adjust for the timing items: an increase in receivables is subtracted, because that is revenue counted but not collected; an increase in payables is added, because that is cost counted but not yet paid; an increase in stock is subtracted, because money went into goods still sitting on the shelf. Finally subtract the three cash-only items above, being capital purchases, loan principal repaid, and owner drawings.

The result should approximate the change in the bank balance over the period. If it does not, either an adjustment has been missed or something is recorded incorrectly, and both are worth knowing. This calculation is the indirect method of preparing a cash flow statement, and it is the third statement alongside the profit-and-loss and the balance sheet. Very few small businesses in India produce one monthly, which is why the divergence tends to be discovered by a failed payment rather than by a report.

The gap does not usually open suddenly. It widens over several months while the profit-and-loss statement continues to look acceptable, and there are observable signs during that period.

The first is a bank balance trending down while monthly profit stays flat or improves. Plot both for the last twelve months on the same chart. Diverging lines are the whole warning, and no further analysis is needed to justify paying attention.

The second is receivables growing faster than sales. If sales rose by a tenth and the amount owed to you rose by a third, collection has slowed, and the extra profit is sitting in other people's accounts. The third is your own payment behaviour: paying suppliers progressively later, using the informal grace a long relationship allows, is often the first adaptation a business makes to a cash squeeze, and it is usually done without anyone deciding to do it. If invoices that were paid on receipt two quarters ago are now paid at the end of the month, that is a measurement of your own cash position, and it is more current than any statement your accountant will produce.

Both figures are historical, and neither carries the information that actually determines whether a payment will clear next week.

A cash balance does not know about commitments. The account holding a comfortable sum today may have salaries, a GST payment and a supplier cheque all landing on the same date, and nothing in the balance signals that. Only a forward list of expected inflows and outflows does, and that list has to be written by someone who knows what has been promised. A profit figure does not know which receivables are collectible. Revenue from a customer who has stopped answering the phone is counted at full value in the profit for the month it was invoiced, and it stays counted until somebody decides to write it off.

This is the limit of what any accounting system, manual or software, can establish on its own. It can tell you what was recorded and when money moved. It cannot tell you whether a particular customer intends to pay, whether a verbal order will convert, or what you have committed to over a phone call that was never written down. Those inputs come from the owner, and a cash forecast is only as good as their honesty about them.