Case Study Profit vs. Cash Flow

If you keep your business's books on the accrual method of accounting, you'll have to make some adjustments to determine your actual cash flow. These adjustments are necessary because certain accrual accounting transactions are taken into account to determine your accrual net profit, even though these expenses do not currently require a cash outlay.

The following example looks at the adjustments necessary to convert the accrual profits of Bug Busters Exterminating Service to its cash flow for its year ending December 31, 2002.

To convert its accrual profit to its cash flow profit, Bug Busters will need balance sheets

from the beginning and end of the period it wishes to examine. In this case, Bug Busters will examine the period starting on January 1, 2002, and ending on December 31, 2002. Below is the comparative balance sheet provided by Bug Busters' accountant for December 31, 2001, and December 31, 2002:

Bug Busters Exterminating Service
Comparative Balance Sheets
  12/31/01 12/31/2002
Cash $17,845 $4,375
Accounts Receivable 12,185 27,371
Inventory 6,034 9,133
Property and Equipment 83,239 83,239
Less: Accumulated Depreciation (44,826) (48,989)
Total Assets $74,477 $75,129
Accounts Payable $6,977 $7,630
Notes Payable (Bank Loans) 27,500 12,000
Total Liabilities $34,477 $19,630
Stockholder's Equity $40,000 $55,499
Total Liabilities and Equity $74,477 $75,129

The conversion process also requires an income statement for the end of the period under examination. The income statement of Bug Busters Exterminating Service for the year ending December 31, 2002 is presented below. The income statement was prepared using the accrual method of accounting.

Bug Busters Exterminating Service
Income Statement
December 31, 2002
Sales $267,189
Less: Cost of Goods Sold 132,122
Gross Profit $135,067
Less: Operating Expenses (115,405)
Less: Depreciation (4,163)
Net Profit $15,499

Bug Busters will have to adjust its accrual net profit to determine its cash flow for the year. As a general rule, Bug Busters can convert its accrual net profit using the following formula:

Net Profit
+ Depreciation
- Increases (or + Decreases) in Accounts Receivable
- Increases (or + Decreases) in Inventories
+ Increases (or - Decreases) in Accounts Payable
- Decreases (or + Increases) in Notes Payable (Bank Loans)
= Net Cash Flow

Using the formula above, Bug Busters can adjust its accrual net profit to determine its cash flow for the year:

Adjustment Description Amount
Net Profit--December 31, 2002 $15,499
Add: Depreciation 4,163
Subtract: Increase in Accounts Receivable between 12/31/01 and 12/31/2002 (15,186)
Subtract: Increase in Inventory between 12/31/01 and 12/31/2002 (3,099)
Add: Increase in Accounts Payable between 12/31/01 and 12/31/2002 653
Subtract: Decrease in Notes Payable between 12/31/01 and 12/31/2002 (15,500)
Net cash flow for the year ended December 31, 2002 ($13,470)

Bug Busters' accrual net profit and the net cash flow for the year ended December 31, 2002, report two entirely different results. The income statement prepared using the accrual method of accounting reports a profit of $15,499 for the year. However, in terms of a cash flow, Bug Busters had a negative cash flow of $13,470 for the same year. In other words, Bug Busters spent $13,470 more than it collected during the year.