The company is making a profit, but the account is empty. Where did the money go?

This is one of the most common misunderstandings among entrepreneurs.

The accountant says: the company has a profit. The profit and loss account shows, for example, 100,000 EUR in profit. But the company's bank account only has 10,000 EUR.

A logical question arises: Where is the money? The answer is simple — profit is not the same as money.

To understand how much free cash a company actually has, a much more important indicator is Free Cash Flow (FCF) .

Profit does not mean money has been received

Let's say a company has issued an invoice to a customer for 50,000 EUR. In accounting, revenue has already been recognized, and it increases the company's profit. However, the customer has a 60-day payment period. So there is profit, but there is no money in the account yet. We will see this amount on the balance sheet as accounts receivable. The more the company grows and the more money gets stuck in unpaid invoices, the greater the difference between profit and the actual available money can be.

Money may be frozen in warehouse

A similar situation occurs with goods. A company buys goods for 100,000 EUR and pays the supplier. The money has left the account. However, in the income statement, these 100,000 EUR do not immediately become an expense. Until the goods are sold, they are on the company's balance sheet as inventory. As a result, the company's profit may look good, but a large part of the money is actually sitting in storage.

The company may have invested in fixed assets

Let's say a company buys a new piece of equipment for 200,000 EUR. The entire 200,000 EUR leaves the bank account. However, the income statement will not typically show the 200,000 EUR expense on a single day. The value of the equipment will be written off gradually, for example over five or ten years, using depreciation.

Therefore, a company can have very good profits and at the same time have negative cash flow. The money has simply been converted into a factory, cars, servers, equipment or other assets.

That's why you need to look at free cash flow

In a simplified way, free cash flow can be viewed as follows:

Free cash flow = cash from operating activities – investments in fixed assets

Cash from operating activities, on the other hand, is affected not only by the company's profit, but also by customer debts, supplier debts, inventory changes, taxes paid, other working capital items. Therefore, a company with a profit of 100,000 EUR can theoretically have both +150,000 EUR and -100,000 EUR in free cash flow.

These are completely different financial positions of the company.

Example

The company's profit is +100,000 EUR. However, during the year:

• unpaid customer invoices increase by 40,000 EUR;

• inventory increases by 30,000 EUR;

• New equipment was purchased for 50,000 EUR.

To put it simply: 100,000 – 40,000 – 30,000 – 50,000 = –20,000 EUR

The company has been profitable, but the amount of money has actually decreased. And here comes the feeling of an entrepreneur: “ The accountant says we have a profit, but the account is empty. ” Both statements are absolutely correct.

But is the account balance free money?

No. If a company has 100,000 EUR in its account, this does not mean that the owner can safely take 100,000 EUR in dividends. It is possible that in a few days salaries, VAT, social contributions, supplier invoices, loan payments, rent, and other company expenses will have to be paid.

Therefore, the company manager is actually interested not only in “How much money do we have in the account?”, but also in: “ How much money does the company generate itself and how much of it remains freely available after the necessary investments? ”

This is exactly the question that free cash flow tries to answer.

Profit shows profitability. Cash flow shows reality.

The income statement is extremely important — it shows whether a company's operations are economically profitable. However, to understand a company's ability to:

• to pay dividends;

• repay loans;

• to save;

• to invest;

• or simply survive without additional funding,

You also need to look at cash flow.

A good company doesn't just show profits in the long run. It is able to turn those profits into cash.