When profits rise but cash runs low
A COMPANY announces another profitable year. Sales are growing, earnings are improving, and management is optimistic about the future. On paper, everything seems to be going well.
But behind those encouraging numbers is something that deserves closer attention: The company is generating less cash from its operations even as its reported profits continue to rise.
How can that happen? The answer lies in a distinction often overlooked in business: Earning a profit is not the same as generating cash.
Consider a Philippine trading company that reports a net profit of P2 million in its first year, P3 million in its second, and P4 million in its third. Looking at the income statement alone, one might conclude that the business is becoming more successful.
Now suppose its operating cash flows tell a different story. In the first year, the company generated P1.5 million from operations. In the second year, this declined to P500,000. By the third year, its operations resulted in a net cash outflow of P1 million.
The company is reporting higher profits, yet its operations are consuming cash rather than generating it.
Does this mean the company is in trouble? Not necessarily. But it raises questions that management, investors, and lenders should not ignore.
Under accrual accounting, revenue may be recognized before customers pay. A company selling goods on credit can report revenue and profit even when it has yet to collect the corresponding cash.
Suppose a trading company has been expanding sales by offering customers longer payment terms. Sales are increasing, but customers are also taking more time to settle their accounts.
The additional sales appear in the income statement. The cash, however, may not arrive until much later.
A similar situation can arise with inventory. A company expecting higher demand may purchase additional merchandise. These purchases are generally recorded as inventory rather than as an immediate expense, but paying suppliers still requires cash.
If the merchandise remains unsold, a significant amount of money may be tied up in inventory.
This is where Philippine Accounting Standard (PAS) 7, Statement of Cash Flows, becomes useful. It requires companies to present cash flows from operating, investing and financing activities. These classifications help readers understand where cash comes from and how it is used.
For anyone assessing the quality of a company’s earnings, operating cash flow deserves particular attention. It shows whether regular business activities are generating or consuming cash.
A profitable company with consistently weak operating cash flows may need to examine its collection practices, inventory management and payment arrangements.
Negative operating cash flow, however, does not automatically mean a business is failing. A growing company may temporarily use more cash as it builds inventory or extends credit to attract customers. Seasonal businesses may also experience significant gaps between sales and collections.
The important question is whether the situation is temporary or becoming a pattern.
In our example, operating cash flow has deteriorated for three consecutive years, while profits have continued to increase. That trend deserves investigation.
Management should ask whether receivables are being collected on time, whether inventory is moving as expected, and whether expansion is putting too much pressure on available cash.
A company can also increase its cash balance without improving its operations. If a trading company borrows P5 million from a bank, its cash balance increases. But the borrowing is a financing cash inflow, not cash generated from regular business activities.
The company has more money to spend, but it also has an obligation to repay. This is why the income statement and the statement of cash flows should be read together.
Profit provides information about financial performance. Operating cash flow offers another perspective, showing how much cash the company’s regular activities have generated or used. Neither tells the complete story on its own.
For business owners, the lesson is practical. Increasing sales and improving profit margins are important, but so are collecting receivables, managing inventory, and planning cash requirements.
A profitable year is worth celebrating. But when profits keep rising while operating cash flows steadily decline, it may be time to look more closely at what is happening behind the numbers.
Profits may tell a promising story. Cash flows help show whether the business has the money to sustain it.
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Floyd C. Paguio, CPA, MBA, is chairman of Paguio, Dumayas & Associates, CPAs, the Philippine member firm of PrimeGlobal International, and the president of KCD College of Accountancy in Alaminos, Laguna.
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