Spot Profit Mirages by Separating Cash Flow from Accounting Profit
In early 2021, a mid-sized software firm boasted rising profits, but its CFO sounded uneasy. Sales were up 25 percent, and the P&L showed a tidy profit. Yet the finance team was scrambling every month to make payroll. A closer look at the cash flow statement revealed the culprit: The company sold its new subscription bundle with 90-day payment terms, while its own server vendor still demanded payment within 30 days. As a result, cash was building up in accounts receivable while payables were piling up unexpectedly.
Management realized that the accounting profit—while technically correct—was a mirage. The firm was profitable on paper but risked turning down servers and shuttering operations if the cash squeeze persisted. When the CEO saw the operating cash flow reconciliation, which started with net profit, added back depreciation, and subtracted the rising AR reserve, she ordered immediate adjustments. She negotiated 60-day terms with the vendor and reduced subcontractor retainer builds to free up cash.
Within two quarters, operating cash flow turned solidly positive. The board breathed easier and approved funding for a customer success initiative. By separating cash from profit, the managers turned a leadership crisis into an operational advantage—proving that real money matters more than accounting numbers.
Walk through your company’s P&L and cash flow statements side by side. First, add back noncash charges like depreciation and amortization to net profit. Then, adjust for changes in working capital by subtracting increases in accounts receivable and inventory and adding rises in payables. Finally, plot this operating cash flow month by month. You’ll see when the business truly has cash on hand versus when profit is just a line on paper. Tackle any shortfalls by renegotiating payment terms or building a cash reserve.
What You'll Achieve
You’ll avoid cash crunches by understanding the gap between accounting profit and real cash flow, enabling you to secure necessary funding and plan resilient operations.
Trace the True Flow of Your Money
List noncash expenses
Identify items like depreciation and amortization on your P&L. These reduce accounting profit but do not use actual cash in the period.
Track working capital changes
Compare accounts receivable, payable, and inventory between balance sheets. If receivables rise faster than payables, cash is tied up in the business.
Compile operating cash flows
Start with net profit, add back noncash expenses, and adjust for working capital. This reconciliation reveals your real cash generated.
Plan for cash timing
Identify months when cash inflows and outflows mismatch—large capex, debt payments, or inventory buildup—to ensure you have reserves or credit lines.
Reflection Questions
- When did your business last hit a cash squeeze despite reported profits?
- How could shifting payment terms for customers or suppliers improve your cash runway?
- What non-cash expenses most distort your view of operational performance?
Personalization Tips
- In your side gig: After buying components for each gadget you sell, adjust your sales income by the mounting unsold kits in stock.
- Running a household: If your mortgage payment peaks early in the year, but your bonus arrives in summer, plan a cash buffer.
- On a team project: Notice that each milestone completion increases work-in-progress, so budget extra time and resources to bridge the gap.
The 12-Week MBA: Learn the Skills You Need to Lead in Business Today
Ready to Take Action?
Get the Mentorist app and turn insights like these into daily habits.