3.7.1 Difference Between Profit and Cash Flow Notes

Differentiating Profit and Cash Flow

1. A business can be profitable but still run out of cash.
2. While profit measures how much money remains after covering costs, cash flow determines whether a business can pay its bills on time.
3. Many businesses fail not because they are unprofitable, but because they lack cash when they need it.

Why a Profitable Business May Lack Cash

A business can generate profit but still struggle with liquidity due to the timing of cash inflows and outflows.

1. Delayed Customer Payments

1. Many businesses sell goods on credit, meaning customers take 30, 60, or 90 days to pay.
2. This creates a gap where the business must cover expenses (e.g., rent, wages, supplier payments) before receiving cash.

2. High Stock Levels

1. Businesses that hold large amounts of inventory (e.g., jewelers, car dealerships) have significant cash tied up in stock.
2. Until those items are sold, the cash is not available for daily operations.

3. Investment in Non-Current Assets

1. Purchasing equipment, machinery, or property requires large cash outflows upfront, even though these assets generate revenue in the long run.
2. This can cause short-term cash shortages despite long-term profitability.

Why Cash Flow Is Critical

1. Profitability is important, but cash flow is what keeps a business running.
2. Many firms fail despite reporting profits because they lack the cash to pay suppliers, employees, and creditors on time.
3. A business must manage its cash flow effectively by:
   1. Speeding up receivables (e.g., encouraging customers to pay sooner).
   2. Controlling expenses to avoid excessive outflows.
   3. Maintaining a cash buffer for emergencies.

Key Differences Between Profit and Cash Flow

1. Timing: Profit is recorded when a sale is made, regardless of when cash is received. Cash flow tracks actual cash movements.
2. Scope: Profit focuses on overall financial performance, while cash flow emphasizes liquidity and operational sustainability.
3. Purpose: Profit shows long-term viability, cash flow ensures short-term survival.

Case study

Tesla's Liquidity Management

• Tesla sustained itself despite years of losses primarily through strong liquidity management.
• It maintained significant cash reserves by raising capital through stock offerings, leveraging its high valuation to secure billions without adding debt obligations.
• The company also accessed loans and credit facilities, such as a USD 1.6 billion loan for its Shanghai Gigafactory, ensuring liquidity for expansion.
• Another key source of cash flow was revenue from carbon credit sales, which brought in USD 1.58 billion in 2020 alone, helping offset financial losses.
• Despite reporting net losses, it generated positive operating cash flow, reaching USD 964 million in free cash flow in Q2 2020.
• Through a combination of capital raising, debt financing, carbon credit sales, and efficient cash flow management, Tesla ensured sufficient liquidity to survive and expand.