Profit and Have No Cash?

¶ … Profit and Have No Cash?

Is it possible for a business to be profitable and still have no cash at the same time? In this text, I present a number of scenarios that indicate that a business can indeed be profitable but still have no cash. In so doing, I also develop measures an entity could take to remedy such a problem.

There are many factors that contribute to a "profitable but broke" scenario. To begin with, such a situation could arise if a business has collection practices that are particularly poor. In this case, the business entity could be recognizing income but at the same time failing to collect the cash at a rate that could be regarded fast enough. The most effective solution to this problem is enhanced cash collection. To determine how quickly it collects cash from debtors, a business could make use of the receivables turnover ratio which in the words of Jones, Heitger, Mowen, and Hansen (2011) "indicates how many times accounts receivable is turned over each year" (p.607). As the authors further point out, a firm with efficient credit-granting as well as credit-collection activities turns over accounts receivable more times each year. Such a business would ordinarily have a significantly high receivables turnover ratio and for this reason, it cannot find itself in a situation whereby it is making a profit (recognized income) but has no cash (uncollected cash). It is however important to note that businesses that find themselves with a low receivables turnover ratio have a number of options to explore in seeking to remedy the situation. Such businesses could amongst other things consider conducting a reassessment of their credit policies so as to ensure that all their accounts receivables are collected on a timely basis.

Next, paying suppliers too early could push a business to a situation whereby it has no cash despite making a profit (Weil, Schipper, and Francis, 2009). By paying suppliers too early, a business could deplete its available cash reserves. This effectively means that the ability of the said business to deploy funds for growth or expansion is limited. Should this be the case, then a business could tweak its vendor payment policies appropriately to rein in the problem. This could be done by amongst other things fully exploiting the credit facilities available. For instance, instead of paying for goods or services immediately, a business could negotiate with the vendor to be allocated more time to pay for the said goods and/or services. The business can use the proceeds of sales to pay the vendors without having to dig into its reserves. A business servicing a loan could also find itself cash strapped despite making a profit. This is more so the case in those instances where the repayment terms are oppressive and unfair, i.e. In those instances where the business is forced to part with huge installments on a periodic basis or where repayment terms are readjusted as a result of changes in the prevailing interest rates. Negotiating better repayment terms is one of the measures a business could take to remedy the situation.

It is also important to note that a business could end up ordering so much stock that it finds itself without cash. Indeed, as Needles and Powers (2007) observe, a business entity's free cash flow could be reduced by excessive inventories. To illustrate this point, I will make use of an illustration. Assuming that Company XYZ buys Product Q. For $5 and offers it for sale at $7, the company would make a profit of $2 with each single sale. If Company XYZ manages to sell 100,000 pieces of Product Q. every quarter, then it would rake in $200,000 in profits on a quarterly basis. Assuming that the company does not use this amount, it would have in its coffers a total of $2,100,000 by the end of the third quarter. Now, should the top executives of Company XYZ suspect that for some reason the demand for Product Q. will go up in the fourth quarter, they could end up ordering for more pieces of the same so as to satisfy the anticipated demand. Assuming that the company purchases 400,000 units of Product Q. At a total of $2,000,000, it would have only $100,000 left in its coffers. Assuming that the consignment arrives on time but the expected increase in demand for Product Q. does not come to pass, the company could be left holding stock worth $2,000,000. Although, the business is still profitable (assuming it continues to sell the normal 100, 000 units), it could find itself broke to an extent where it may not be able to finance capital projects. This is more so the case given that the normal revenues it gets could be tied up in other commitments. In other words, although the business could be making a profit, it could still be cashless.

A business could also find itself with no cash on hand despite making a profit in other numerous instances due to poor planning and imprudent decision making. This is more so the case in those instances where a business entity decides to make a prepayment for the future only for the said prepayment to be recognized as an incurred expense over time. For instance, the executives of Company XYZ could purchase a multi-year comprehensive insurance package in the month of July and pay up front for the said cover. Assuming that the total amount of money paid in this case is $500,000, what the company essentially does is make present payment for insurance coverage running so many years into the future. It should in this case be noted that accounting rules permit a business entity to claim only a faction of such an expense annually. Assuming that Company XYZ's profits for the year were $300,000, a more informed look at the scenario reveals that the company's cash flows are actually negative. Thus while Company XYZ's Finance Manager could report a profit of $300,000, the company in effect has a negative cash flow of $200,000 ($500,000 - $300,000). Should nothing be done to remedy the situation at this point, the company could end up running out of cash to oversee day-to-day operations despite having reported a profit. It is clear from the above scenario that net income as Brigham and Ehrhardt (2011) observe "is not equal to the cash flow available for distribution to investors" (p.425).