You've now mastered how the balance sheet captures your company's financial position and how the income statement reveals profitability over time. You understand how the cash flow statement tracks money moving through operating, investing, and financing activities. But here's a paradox that confuses even experienced managers: Why would a profitable company struggle to pay its bills? And conversely, how could a company losing money have plenty of cash in the bank? This lesson explores one of the most critical distinctions in finance—the fundamental difference between profit and cash. Through two contrasting bakery and cigar shop examples from the HBR Guide to Finance Basics for Managers, you'll discover why profit doesn't equal cash and learn to recognize the three specific mechanisms that create this disconnect.
The relationship between profit and cash is perhaps the most misunderstood concept in business finance. When your income statement shows $347,500 in net income like Amalgamated Hat Rack, you might expect to see that same amount flowing into your bank account. But as you learned in the cash flow lesson, Amalgamated only generated $291,000 in operating cash—a gap of $56,500. This wasn't an anomaly; it's the normal state of business. Sweet Dreams Bakery and Fine Cigar Shops represent extreme versions of this phenomenon, demonstrating how payment timing, inventory management, and capital investments can create dramatic divergences between what you earn on paper and what you have in the bank. Understanding these dynamics will transform how you think about budgeting, growth planning, and resource allocation.
Sweet Dream Bakery simplified income statement
Sweet Dreams Bakery perfectly illustrates how a growing, profitable business can run out of cash and fail. This new cookies-and-cakes manufacturer supplies specialty grocery stores with unique home-style recipes. Starting with $10,000 in the bank on January 1, the company projects sales of $20,000, $30,000, and $45,000 over its first three months. With cost of goods sold at 60% of sales and monthly operating expenses of $10,000, the income statement shows losses of $2,000 in January, followed by profits of $2,000 in February and $8,000 in March. On paper, the business appears to be turning the corner toward sustainable profitability.
But the cash reality tells a devastating story. Sweet Dreams negotiated 30-day payment terms with its suppliers for ingredients, which seems reasonable. However, those specialty grocery stores that buy its products are "kind of precarious" and demand 60-day payment terms. This 30-day gap between when Sweet Dreams must pay its suppliers and when it collects from customers creates a cash flow nightmare.
In January, Sweet Dreams collects nothing from its customers. At the end of the month, all it has is $20,000 in receivables from its sales. Luckily, it does not have to pay anything out for the ingredients it uses, since its vendors expect to be paid in 30 days. But the company does have to pay expenses—rent, utilities, and so on. So all the initial $10,000 in cash goes out the door to pay expenses, and Sweet Dreams is left with no cash in the bank. A simplified representation of the company's checkbook would look like this:
Fin Cigar simplified income statement
Fine Cigar Shops presents the mirror image of Sweet Dreams—a company hemorrhaging money on its income statement while accumulating cash in the bank. This upscale cigar retailer in a business district shows losses of $15,000, $7,500, and $1,500 over its first three months, with sales of $50,000, $75,000, and $95,000 respectively. Cost of goods runs 70% of sales, and monthly operating expenses are $30,000 due to high rent in the premium location. Any investor looking solely at the income statement would see a struggling business that hasn't achieved profitability and might conclude it's heading for failure.
Yet Fine Cigar's bank account tells an entirely different story. Starting with the same $10,000 as Sweet Dreams, the company ends January with $30,000 in cash, February with $75,000, and March with an impressive $105,000. How is this possible? The key lies in Fine Cigar's business model: as a retailer, it collects cash immediately at the point of sale—customers pay for their expensive cigars before leaving the store. Meanwhile, Fine Cigar negotiated 60-day payment terms with its suppliers, meaning it doesn't pay for inventory until two months after receiving it. This creates a powerful cash flow advantage called float where the company uses its suppliers' money interest-free for 60 days.
The mechanics of Fine Cigar's cash accumulation reveal the power of payment timing.
In January, it begins with $10,000 and adds $50,000 in cash sales. It doesn't have to pay for cost of goods sold yet, so the only cash out the door is that $30,000 in expenses. End-of-the-month bank balance: $30,000. Here's a simplified representation of the company's checkbook:
Berman and Knight identify three fundamental reasons why profit and cash diverge, providing a framework that explains not just Sweet Dreams and Fine Cigar, but every company's cash flow dynamics. First, "revenue is booked at sale" means that companies record income when delivering products or services, regardless of when payment arrives. When Ace Printing delivers $1,000 worth of brochures, it immediately records $1,000 in revenue and calculates profit by subtracting costs. But the customer typically has 30 days or more to pay, meaning no cash has changed hands. This accrual accounting principle—matching revenues to the period when they're earned rather than when they're collected—creates the systematic gap between profit and cash that destroyed Sweet Dreams Bakery.
Second, "expenses are matched to revenue" rather than to cash payments, creating further timing disconnects. The income statement includes all costs associated with generating revenue during a period, whether or not those expenses were actually paid then. Some expenses might have been paid months earlier, like annual insurance premiums, while others won't be paid until later, such as accrued bonuses or supplier invoices. Depreciation exemplifies this principle perfectly—when Amalgamated records $42,500 in depreciation expense, this reduces net income without requiring any cash payment. The company paid for equipment years ago, but the expense appears gradually over the asset's useful life. This matching principle ensures that income statements accurately reflect economic reality but makes them unreliable indicators of cash position.
Third, "capital expenditures don't count against profit" immediately, even though they require immediate cash outlays. When a company buys $50,000 in new equipment, the entire amount leaves the bank account immediately, potentially creating severe cash strain. Yet only a small depreciation charge—perhaps $5,000 annually over 10 years—appears on the income statement. This explains why rapidly growing companies often face cash crises despite strong profitability: they must pay for expansion investments upfront while receiving the profit benefits over many years. The reverse also occurs when companies stop investing—depreciation expenses continue reducing profit even though no cash is being spent, making cash flow temporarily exceed net income.
These three mechanisms interact to create complex cash flow patterns that confuse even experienced managers. Consider a typical growth scenario using Amalgamated's numbers: The company shows $347,500 in net income, but $43,000 of increased receivables means that much revenue hasn't been collected. Another $80,000 went to building inventory that hasn't been sold. Add back in non-cash depreciation expense, and you arrive at operating cash flow of —far below net income. Each component follows the framework: revenue booked before collection, expenses that don't match cash payments, and capital investments that don't immediately affect profit. Understanding these three reasons transforms abstract accounting concepts into practical management tools for predicting and managing cash flow.
