Profitable but short of cash: why it happens
Profit is recorded when a sale is made; cash arrives when the customer pays. If receivables and inventory grow in between, a company can be profitable while its cash shrinks. When the gap gets large enough, a profitable business can still fail for lack of cash.
Formula: turning profit into cash
Operating cash flow ≈ net income + depreciation − increase in receivables − increase in inventory + increase in payables
- Depreciation is an expense that uses no cash, so it is added back.
- An increase in receivables is revenue not yet collected, so it is subtracted.
- An increase in inventory is stock paid for but not yet sold, so it is subtracted.
- An increase in payables is purchases not yet paid for, so it is added.
Even without a cash flow statement, two years of balance sheets and income statements are enough to estimate it this way (the indirect method). Caveat uses the same approach.
Worked example
Figures in units of 100 million KRW. Revenue grew from 24 to 30 and net income was 2. Over the same period receivables rose from 2 to 5 and inventory from 2.5 to 4 (values calculated by the Caveat engine).
| Item | Cash effect |
|---|---|
| Net income | +2 |
| Depreciation | +0.3 |
| Increase in receivables | −3 |
| Increase in inventory | −1.5 |
| Increase in payables | +0.3 |
| Operating cash flow (estimate) | −1.9 |
The company earned 2 on paper, but operations consumed about 1.9 in cash. The growth in receivables and inventory tied up more cash than the profit produced. The cash conversion cycle lengthened from 58.3 to 102.3 days.
How to read it
- What absorbed the cash: the largest negative line is the cause. For receivables, look at collection terms; for inventory, at purchasing and production plans.
- Faster than sales: if receivables grow 150% while revenue grows 25%, as in the example, credit terms may have loosened or some customers may be paying late.
- One year or a pattern: a single negative year matters less than a gap between profit and cash that keeps widening.
Both sides: fast-growing businesses often run short of cash because receivables and inventory grow first. If growth is the cause, working-capital financing or renegotiated payment terms can bridge it. If revenue is flat while receivables and inventory keep rising, it may point to uncollectable debts or slow-moving stock and deserves a closer look.
Look at these too
- Cash conversion cycle (CCC): how many days cash is tied up in operations
- Current and quick ratios: whether there is enough short-term liquidity to carry it
- Interest coverage ratio: whether interest is affordable if the gap is funded with debt
Limitations
- It uses year-end balances, so movements during the year are not visible.
- Investing and financing cash (capital spending, borrowing and repayment, dividends) is excluded, so it can differ from the change in the bank balance.
- Non-cash items other than depreciation (such as provisions) are not adjusted for.
- For reference only; it does not replace credit, investment or tax decisions.
See it in your own statements
Upload a balance sheet and income statement and Caveat calculates these for your company.
FAQ
- Can a profitable company go bankrupt?
- Yes. If receivables and inventory grow faster than profit turns into cash, a company can be unable to pay its bills while still reporting a profit.
- Can I check this without a cash flow statement?
- Yes. Two years of balance sheets and income statements are enough to estimate operating cash flow from changes in receivables, inventory and payables.
- Is cash below profit always a bad sign?
- No. It is common during growth. Compare how fast receivables and inventory grew against revenue, and whether the pattern repeats over several years.
- Where should I start to ease a cash shortage?
- Start with the item that absorbed the most cash in the calculation. Usually it is the collection period on receivables or the level of inventory.