The Profit Paradox: Understanding the Disconnect Between Profit and Cash Flow

One of the most common questions we receive from clients is “Our reports show we are making a profit but I don’t have any money in the bank. What is going on? ”

Most businesses send cash out that is not reported as an expense against profit. This is why it’s so important to track BOTH your profitability AND cash flow.

 A common example of activity that impacts your cash without impacting profitability is when you are paying down loans & credit cards. You might also be purchasing assets, taking owners draws, or investing in expansion. These types of expenses remove cash from your business but they aren’t always reported as an expense that the business can deduct on tax returns. 

Let’s work through an example: Jordan is an independent contractor who works in small-scale construction and carpentry. She owns a work truck vehicle that she purchased with a vehicle loan. Let’s look at how this vehicle purchase and payments affect her profitability and cash situation. 

• The price of the vehicle is $60,000. As soon as Jordan signs the agreement, the truck is added as an Asset on her balance sheet. The vehicle loan is also added as a Liability on her balance sheet. 

  • Notice this does NOT affect her Real Cash or Profit. 

• Jordan paid a $5000 down payment out of her bank account, reducing both her cash and her loan amount.

  • BUT… this amount does NOT reduce her profitability or the asset value.

• The lender charges Jordan interest at a rate of 7%, approximately $320 per month. This is an expense to the business that can be deducted immediately, even though the cash doesn’t actually come out of her account. Instead, it increases her loan balance, without affecting the asset value.

• Jordan makes monthly payments of ~$1667, coming right out of her account and reducing the loan balance. 

  • Critical Point: These payments are not deductible to the business. Loan accounts very often work this way, and it’s a huge reason why Jordan and other entrepreneurs can be shocked by their tax bill despite having low funds. 

• She CAN deduct the depreciation amount of $12,000, based on the IRS dictating that vehicles will have a useful life of 5 years. 

At tax time, Jordan is shocked to learn that she can only deduct a total of $15,480 paid on the vehicle this year, even though a whopping $25K came out of her accounts. 

Now if your eyebrows are inching up there, yes, there is a special depreciation tax break she can take to claim more than this amount, called a Section 179 election. We’ll save that for another day - the goal of this article is to help you understand why you may be seeing higher profit than seems to make sense for cash on hand. 

Debt can be a powerful tool to facilitate greater profits, especially during periods of growth and expansion, but it is important to understand how these decisions will affect your entire financial situation, not just your current cash availability. We have seen several successful companies fail because they took out excessive loans or maxed out their credit cards, only to be faced with the payments not reducing profitability when they need it 

Uncle Sam demands his piece. 

Did this article help you navigate your profit vs cash situation? Let us know! 

If it’s clear as mud, we can help. Our team of nerds loves getting in the weeds of cash flow management, profit forecasts, and tax planning. Send us an email to connect: hello@sonderaccounting.com.