How can a company make profit but still be cash flow negative?

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The question being asked can be refined into two very different questions. I go into both questions below using the example of CyrusCo, which makes twerking gadgets. The company is run by its CEO Miley.

1)  How can a company make an accrued profit but still be cash flow negative?

2) How can a company make a cash profit but still be cash flow negative?

Regarding the first question:1)  How can a company make an accrued profit but still be cash flow negative?

  • GAAP accounting is based on the accrual method of accounting, not the cashmethod of accounting. The accrual method records revenues when they are earned. The cash method of accounting records revenues based on when the actual cash is received.
  • The Cash Flow Statement is one of the three primary financial statements for GAAP accounting, with the Income Statement and Balance Sheet being the other two. The Cash Flow Statement is made up of 3 segments: Cash Flows from OperationsCash Flows from Investments and Cash Flows from Financing.
  • The first line in the Cash Flow Statement isn't cash revenues but actually net income. Net income is the last line from the Income Statement. Why is this the first line on the Cash Flow Statement? What the Cash Flow Statement actually does is it starts with net income and makes adjustments and reconciliations for (i) non-cash and cash items from the Income Statement and (ii) non-cash and cash changes in the Balance Sheet to arrive at a true change in Cash Flows from Operations for the fiscal period being measured.
  • GAAP accounting is based on rules made primarily for keeping score on operational performance. Because the timing of actual cash inflows and outflows can be lumpy, even within the same industry, GAAP through its accrual method of accounting enables you to make more of an apples-to-apples comparison for similar companies being measured in a given time period, especially if the companies are at different stages of growth. But more than anything, GAAP is a way to make earnings and performance look smoother and more predictable by using accrual accounting. This smoothing makes it easier for analysts, especially equity analysts, to make more "predictable" models and price targets. You notice, most investors and analysts focus on EPS as the denominator in the P/E ratio. But net income per share or earnings per share or EPS is rarely a pure cash figure; the theory is, over time, the actual cash flows available to equity holders shouldapproximate the net income figure, especially in aggregate over a long period of time.
  • So here is an example of how a company can be profitable on an accrued GAAP basis but cash flow negative:During the month, CyrusCo received a $100 order for its new twerking gadget. The customer made the purchase online using a credit card. So CyrusCo records $100 of revenues earned for the month on its Income Statement. Assume that it cost CyrusCo $25 in costs and inventory to make and deliver the twerking gadget. Assume there are no taxes. The Income Statement for the month looks like this: $100 revenues - $25 costs = $75 profits or $75 net income. The twerking gadget is shipped to the customer the same day; however, the month has now ended and the credit company has yet to pay the $100 cash to CyrusCo. So what ends up happening is this. On the Cash Flow Statement, you have: $75 net income - $100 increase in accounts receivable = -$25 Cash Flows from Operations, which is negative cash flow. Because the $100 cash has yet to be received from the credit company, it's recorded as an increase of $100 in accounts receivable, so you have to adjust the $75 net income because it was purely accrued earnings and 100% non-cash.
  • This makes sense because the inventory and the costs you spent to make and deliver the twerking gadget are all sunk costs: -$25. You just haven't received the cash revenue of $100, yet, to offset the cash costs.
  • Additionally, if CyrusCo were to immediately replace the recently sold twerking gadget by buying new inventory with cash, that increase in inventory will put Cash Flows from Operations further into the red, as the company will be buying new inventory with cash upfront, while still waiting for the $100 of cash from the credit card company for the first twerking gadget that had already been sold.

Regarding the second question: 2) How can a company make a cash profit but still be cash flow negative?

  • So going back to the example above, assume the customer didn't use a credit card but used cash instead. So $100 cash was paid upfront to CyrusCo for the twerking gadget. So the Income Statement looks the same: $100 revenues - $25 costs = $75 profits or $75 net income. The twerking gadget is shipped to the customer the same day. On the Cash Flow Statement, you have: $75 net income - $0 increase in accounts receivable = +$75 Cash Flows from Operations, which is positive cash flow. No adjustment had to be made for an increase in accounts receivable because all the revenues were already received immediately as $100 cash from the customer.
  • Now, there are still two segments of the Cash Flow Statement remaining that can drive this +$75 Cash Flows from Operations into the red: 1) Cash Flows from Investing and 2) Cash Flows from Financing.
  • If the twerking gadgets are flying off the shelves and CyrusCo's CEO Miley realizes that she needs to expand manufacturing capacity, she could invest in building a new plant by spending $1,000 in growth capital expenditures. Cash Flows from Investing would then show -$1,000. With the +$75 of positive Cash Flows from Operations, CyrusCo would have net cash flow so far of +$75 minus $1,000 = -$925 cash flow. This is negative cash flow.
  • Now, with the last remaining part of the Cash Flow Statement, Cash Flows from Financing, the following could occur. To finance the growth capital expenditures for the new plant, CyrusCo could have raised capital from the debt markets with a bond offering. Say, the bond offering was for $800. So Cash Flows from Financing will show +800 cash proceeds from the bond offering. This will only offset the -$925 in cash flow so far by +$800.
  • So putting it all together: Cash Flows from Operations = +$75 Cash Flows from Investing = -$1,000 Cash Flows from Financing = +800 Total Net Change in Cash = -$125
  • This negative cash flow of -$125 occurred even though you still had cash profits of $75.