Why profit is not the same as cash, with a worked bridge

The situation

Oasis Retail, the group's Saudi store business, reports a net profit of SAR 7.2 million for the year. Hana, the group CFO, looks at the bank balance, which has fallen, and asks Farida for one thing: we made 7.2 and have less cash, explain.

Farida's first instinct is to look for missing money. There is none. The profit is real and the cash is real. They simply measure different things, and the gap between them can be listed, item by item.

The explanation

Profit follows the accrual basis. It records revenue when it is earned and cost when it is incurred, whatever the bank did. Cash follows the bank. The gap has five usual sources.

First, non-cash expenses. Depreciation reduces profit but no cash leaves the bank in the period. You add it back when moving from profit to cash.

Second, receivables. When customers have been invoiced but have not paid, revenue is in profit and not in cash. A rise in receivables takes cash away from profit.

Third, inventory. Stock bought but not yet sold is cash spent that has not yet reached the income statement as cost. A rise in inventory also takes cash away.

Fourth, payables. When you owe suppliers more, you have used their money. A rise in payables adds cash to the bridge.

Fifth, investing and financing flows such as capital expenditure, loan repayments and dividends. They are real cash, and most either never pass through profit (loan principal, dividends) or reach it only slowly (capital expenditure, through depreciation). Buying a truck reduces cash today while depreciation touches profit slowly.

IAS 7 organises cash flows into operating, investing and financing activities, and allows operating cash flow to be shown either directly or by the indirect method. The indirect method starts from profit and adjusts it for non-cash items and changes in working capital, which is precisely the bridge in this article. A dated note: IFRS 18, effective for periods beginning on or after 1 January 2027, amends IAS 7 so that the indirect method starts from operating profit instead of profit or loss. The bridge idea does not change; the starting line does.

A fast-growing business is the classic case. Sales grow, so receivables and inventory grow first, and cash goes out before cash comes in. A company can be profitable and still run short of money. That is why lenders and CFOs read the cash flow statement next to the income statement.

Worked example

Oasis Retail, SAR million.

Net profit is 7.2. Depreciation of 6 is added back because it was deducted but not paid. Receivables rose by 2, which is cash not yet collected, so subtract 2. Inventory rose by 5, which is cash spent on stock still on the shelves, so subtract 5. Payables rose by 1, which is cash not yet paid out, so add 1.

Operating cash flow is therefore 7.2 plus 6 less 2 less 5 plus 1, which equals 7.2. By coincidence it equals the profit, but the composition is very different.

Then capital expenditure of 8 is spent on new stores. Free cash flow, a common management measure that IFRS does not define, is operating cash flow less capex: minus 0.8. The example assumes no other adjustments, such as interest or tax timing.

The bridge tells the story Hana needs. The company earned 7.2, but it put 5 into stock, 2 into customers and 8 into new stores. Depreciation of 6 exactly offset the net 6 that working capital absorbed, and free cash flow ends at minus 0.8. Nothing is missing. The business chose to grow, and growth consumed cash.

A good bridge has a check: the start point, plus all adjustments, must equal the cash flow in the cash flow statement. If it does not tie, a line is missing or has the wrong sign.

The common mistake

The common mistake is to treat profit and cash as the same number, so that a company that earned 7.2 million is assumed to hold 7.2 million more cash. It rarely does, and for a growing company it can hold less than the year before.

The second mistake is the sign. A rise in an asset such as receivables or inventory reduces cash; a rise in a liability such as payables increases it. When in doubt, ask whether the company has paid out money it has not yet recognised as cost, or received money it has not yet recognised as revenue.

The third mistake is to read the depreciation add-back as a source of cash. Depreciation does not produce cash. It is added back only to undo a deduction that never used cash.

Checklist

• I start the bridge from net profit and end at operating cash flow.
• I add back non-cash expenses such as depreciation.
• I subtract increases in receivables and inventory.
• I add increases in payables.
• I show capital expenditure and loan repayments below operating cash flow.
• The bridge ties to the cash flow statement.
• I can explain in one sentence why the cash moved differently from profit.

Go further

Watch the full episode FS-E6 Profit is not cash (curriculum sample) and fill in the profit-to-cash bridge in the lesson FS-E6 Profit is not cash (curriculum sample). It must tie before you submit it.

Companies and figures in this article are fictional. Masar-Fintech is independent and not affiliated with any professional body or tax authority.