Cash Profit – The Driving Force for Business Resilience

Summary: In today’s dynamic world, Profit after tax is generally the first number in annual reports captured by the general public and is widely treated as an indicator of how a company has performed. Lenders, analysts and investors compare profit with corresponding periods and use it to assess growth, while management highlights it in presentations to shareholders. However, a healthy net profit does not necessarily guarantee a strong financial position because a business may report substantial profits while facing cash shortages affecting suppliers, debt servicing and payroll obligations. Conversely, a company with moderate or reasonable profit may have a strong cash position reflecting financial strength. The difference principally arises because net profit is determined on an accrual basis and includes non-cash items such as depreciation, provisions, impairment losses, fair value adjustments, expected credit loss adjustments and other accounting estimates, whereas cash profit focuses on actual cash generation by eliminating the effect of major non-cash expenses. Cash profit is therefore discussed in the context of business survival or going concern, creditworthiness, sustainable earnings, liquidity management, cash conversion cycle, management decisions, accounting estimates, investor outlook, dividend payout, capital allocation, financial reporting and early identification of financial stress. Strong earnings remain important, but their credibility is linked with cash generation ability. A disciplined cash conversion cycle, adequate liquidity and efficient capital allocation can support business resilience and financial stability, while excessive dependence on borrowings, long receivable periods, excessive inventory and interest burden can signal financial stress. The article accordingly emphasises that net profit and cash profit perform different roles and should not be interpreted in isolation. Net profit may indicate accounting performance, whereas cash profit provides an important perspective on liquidity and survival, and harmonising both measures is relevant for long-term business resilience.

Abstract

In today’s dynamic world, the first number in all annual reports which gets captured by general public is the Profit after tax. The same is always treated as final indicator about how the company has performed. Lenders, Analyst and Investors do variance analysis by comparing it with respective corresponding periods and also predict the growth of the company. Management highlights the same in presentation to shareholders.

Despite being healthy number, it does not guarantee strong financial position of the company. A business may report substantial profits while struggling cash shortages in terms of inability to pay suppliers, service debt, or to meet payroll obligations. On the other hand, a company with moderate or reasonable profit may be having strong cash position which in turn reflect financial strength of the company in real sense.

The difference is mainly because net profit is calculated on an accrual basis and includes several non-cash items like Provisions, Depreciation and accounting estimates as required by accounting principles whereas Cash profit focuses on actual cash generation by eliminating the effect of major non-cash expenses and provides a clear picture about how the company is managing its operations effectively.

Practically, to understand the difference between the two is very much crucial as the Profit may indicate the performance of company from accounting perspective but cash position ensures the sustainability of performance.

Introduction

Net Profit was regarded as a final indicator about business growth and sustainability. However, the global business environment has highlighted the importance of Cash Profit as the net profit will not always reflect true financial position of the company which we already have witnessed during adverse market scenarios like pandemic and war situations which require reasonable assurance about ability to generate cash profit.

There are practical instances where the company reports healthy number in terms of net profit but facing liquidity crisis due to disrupted business cycle and in such situations, cash profit comes in picture to assess liquidity, credit worthiness and overall financial health & survival of the business.

Strong earnings are undoubtedly important but it is credible only and only if it is supported by cash generation ability.

Understanding Net Profit and Cash Profit

Net Profit

Net profit referred as profit after tax is the residual amount which is derived after deducting all expenses consisting of cash as well as non cash expenditure as under:

• Cost of materials consumed
• Employee benefit expenses
• Administrative and selling expenses
• Depreciation and amortisation
• Finance costs
• Tax expense

Net profit is determined as per accrual accounting system, where all income and expenses are recognised incurred during the year irrespective of actual cash inflow or outflow.

It means income is recognised when to right to receive the same is established and expenses are recognised when services availed or materials consumed.

This approach is conceptually sound because it matches income and expenses to the period in which economic activity occurs.

Cash Profit

Cash profit represents the amount of profit generated before considering non-cash expenses.

It focuses on actual cash generation.

It is generally computed as:

Cash Profit = Net Profit + Non-Cash Expenses

Major non -cash expenses include:

• Depreciation and Amortisation
• Impairment losses
• Fair value adjustment
• Expected credit loss adjustment
• Provisions

Accordingly, Cash Profit provides more reliable picture about the core financial strength of the company which is useful and more importantly required to assess or judge liquidity position, serving dept capacity and last but not least to ensure overall sustainability of a business.

Distinctive Emphasis

Ability to survive or Going concern

Even though, the company reports healthy numbers in terms of net profit, it is very much important to have cash profit as well for survival of a business to meet various financial and operational obligations on time in form of cash like;

• Payment of Salaries and wages
• Repayment of borrowings and interest obligation
• Payment to suppliers
• Payment of statutory dues like income Tax, GST, TDS etc

Accounting profit alone can not ensure smooth business operations; it must be supported by cash generation otherwise company may face liquidity crisis which in turn increases external borrowings for survival which is not at all a good sign for a company.

History says companies failed to survive not because they were unprofitable, but because they were unable to generate sufficient cash to meet obligations as they became due.

Reliable measure for credit worthiness

Lenders like Banks and Financial institutions are more concerned with actual cash generation ability rather than just strong numbers in terms of net profit because at the time of funding and also during entire loan tenure, they have to ensure that whether the company will be able to meet interest and principal obligations as and when they became due.

For this purpose, higher emphasised key performance indicators are as under;

• EBITDA
• Cash Profit
• Interest coverage ratio
• Debt service coverage ratio

Thus, from credit worthiness or financial resilience point of view, cash profit is more reliable than just Net Profit.

Reflects Quality / Sustainable Earnings

This also plays a vital role in terms of reflecting sustainability of earnings.

A higher profit gets reflected in financial statements by;

• Changes in accounting estimates
• Deferment of expense or provision
• Poor fair value measurement
• Higher receivables waiting period
• Lower Trade payables period

Due to this, net profit may be inflated without corresponding effect on cash generation which will impact several key areas of working capital management in terms of higher payables, lower receivables and also to a higher extent of cash credit facilities in banks.

Therefore, assessing quality of earnings at regular intervals is more important to avoid trap of financial crisis.

Liquidity Management

Cash Profit helps to evaluate whether internal funds are sufficient for;

• To maintain inventory lead time
• To support project expansion
• To meet unexpected contingencies
• To meet day to day business operation

As the net profit is derived based on an accrual basis of accounting system, it will not reflect true picture of liquidity position because there will always be a gap between revenue recognition and its actual collection.

Cash Conversion Cycle

It represents time taken by a company to convert its inventory and receivables into actual cash inflow. Survival and stability of any business depend solely on its ability to covert inventory and receivables in cash within a reasonable time period.

Key indicators to understand cash conversion cycle are as listed below;

• Inventory Turnover ratio
• Receivables waiting period
• Trade payable ratio

There are several companies which are facing liquidity crisis even though reporting strong net profit and the reasons behind this are;

• Lower Inventory Turnover
• Receivables remain overdue for a long time
• Ageing bracket (more than 60 days) of trade receivables increasing
• Increasing expected credit loss provision
• Suppliers’ payment terms not aligned with receivables collection

Every company must establish Cash Conversion Cycle considering Inventory lead time, Receivables collection, Suppliers’ payment terms including MSME vendors and this needs to be reviewed at regular intervals via Inventory Management system, Treasury Management system or through some reliable tools as well.

Disciplined Cash Conversion Cycle reflects long term future growth and support financial uncertainties.

Management viewpoint

After all, Management is the owner of strategic decisions which always focus on business performance, future expansions, operational efficiency etc. which all are supported by actual cash availability with the company.

During Pandemic situation, economic slowdown, Geo Political issues, war condition, businesses having cash profit are able to sustain and maintain financial stability.

Efficient Liquidity position helps as under;

• To gain supplier confidence
• To improve borrowing capacity
• To serve interest liability

Thus, in today’s scenario, Management is continuously prioritizing cash flow optimization along with net profit.

Even from Corporate Governance point of view also, cash rich companies are considered to be a more reliable to fulfil stakeholders’ expectations and to avoid excessive external borrowings.

Therefore, Board of directors and audit committees are increasing focus on indicators that provide cash flow generation capacity along with strong bottom line.

Accounting Estimates and assumptions

Net Profit is always being influenced by accounting estimates, assumptions and judgements which are essential in preparing financial statements as per accounting standards and accounting principles.

Key Estimates / assumptions include;

• Expected credit loss assessment
• Impairment testing
• Fair value measurement
• Actuarial assumptions
• Useful life estimation

On the other hand, Cash Profit is comparatively less affected by such estimates and assumptions because it primarily concentrates on actual cash generation ability.

Investor’s Outlook

Investors mostly prefer capital appreciation and dividend receipt which can be possible if the company is having efficient cash conversion cycle.

For valuation, various methods like Income based approach, Market based approach etc are being used by investors.

Accordingly, from investor’s perspective, cash profit provides more reliable insights about company’s future growth and long-term stability which in turn helps to build investor’s wealth.

Dividend payout

Most of the companies as per their annual report are having huge free reserves along with strong bottom line but unable to declare healthy dividend.

In spite of having free reserves and huge net profit, companies may not declare handsome dividend mainly due to weak liquidity, debt burden, future expansion etc.

From above, it is clearly understood that Strategic financial planning and capital allocation decision requires strong presence of cash profit in every business.

Capital Allocation

Apart from dividend payout as cited above, Management is more concerned whether business expansion via new project or some mergers and acquisitions or additional investment in existing plant or technology would take place with available cash balance or not.

Net profit or other indicators would ensure to take decision whether to launch new product or to expand but the sustainability and flexibility largely driven by available cash resources.

Efficient capital allocation is a must in order to complete the project in time and that too without cost overrun and to achieve this level of assurance cash profit plays an important role to assess financial capacity along with future possible opportunities.

Financial Reporting

Conventionally accepted financial statements are having inherent limitations like accrual basis of accounting, non cash expenditure, various estimates in Profit and Loss account statement and also unable to understand changes or variance in assets and liabilities in Balance sheet side.

Due to this, for better and comprehensive understanding of financial position and financial wealth of a business, regulatory bodies introduced Ind AS 7 – “Statement of Cash Flows” and the same is categorised into;

• Operating activities
• Investing activities
• Financing activities

The above classification helps to clear all doubts and confusion regarding sustainability of the company by evaluating;

• Effective business operations
• Solvency
• Ability to meet unexpected contingencies
• Short term and long-term financial stability

Cash Flow Statement starts with opening cash balance and ends with closing cash balance and accordingly between these two pillars, all movements are properly segregated into operating, Investing and Financing activities which makes picture clear from all stakeholders’ perspective.

Early trigger sign

Financial stress has to be identified at an early stage to overcome future contingencies.

There are several indicators as listed below highlight warning signal for a company;

• Long cash conversion cycle
• Excessive inventory
• Dependency on borrowings
• Interest burden

Having known facts about above indicators, Management must take precautionary measures before it becomes too late to survive a business.

Linkages

Despite being significant, cash profit is to be interpreted along with;

• Operating cash flow
• Free cash flow
• Capital expansion
• Long term debt repayment

Illustration

Consider a case where a company is engaged in a business of construction activities which reports healthy profit by recognizing various revenue and expenditure as per applicable accounting standards and accounting principles and accordingly, financial statements look strong and growing.

By analysing financial statements, it shows that significant portion of receivables remain unrealised and on the other hand, various liabilities in form of statutory dues, interest payment, loan principal became due and, in these situations, companies are forced to depend on short term external borrowings to handle liquidity pressure.

This clearly validate that accounting profit must be supported by sufficient cash profit.

Conclusion

Net profit is still an important measure as it helps to calculate various metrics such as;

• Profitability ratios
• Efficiency ratios
• Market prospect ratios

However, profitability alone does not provide clear picture about the health of a business. Net Profit and cash profit both plays an individual and different role as net profit may indicate performance whereas cash profit measures liquidity and survival.

In recent global environment, a temporary slowdown in profitability may be acceptable but cash shortages for a long time cannot be tolerated as the company has to meet various statutory and operational deadlines in terms of tax payment, vendor payment, debt service etc. It is very imperative to evaluate relationship between cash profit and net profit.

Last but not least, Net Profit and Cash Profit both can not be interpreted in isolation as both plays their key roles. The more important is to harmonise net profit and cash profit with each other to ensure long term survival along with business resilience.

‘’ Profitability attracts attention; cash generation earns confidence’’.

References

• Ind AS 1 – Presentation on Financial Statements
• Ind AS 7 – Statement of Cash Flows
• ICAI guidance note on Financial Reporting
• Annual Reports and Financial Statements of listed companies
• Investors’ Presentation of listed companies
• Publication on industry discussion (to some extent)
• Companies Act / SEBI / MCA regulatory guidance