A light balance sheet, and why profit is not cash
What a company owns and owes, working capital, capital spending, and how a profitable company can run out of cash.
Key takeaways
- The balance sheet shows what a company owns and what it owes on one day; profit shows how it performed over a year; and cash is what it can actually spend, which can be very different from profit.
- Common mistakes: Assuming profit equals cash.
- Working capital: money tied up in running the business day to day. In cases, people usually mean operating working capital: receivables plus inventory minus payables.
- Capital spending (capex): money spent on long-lasting assets such as machines.
- Operating spending (opex): day-to-day costs such as salaries and rent, which appear in the P&L when they happen.
Key idea
The balance sheet shows what a company owns and what it owes on one day; profit shows how it performed over a year; and cash is what it can actually spend, which can be very different from profit.
| What it owns (assets) | Amount | What it owes and the owners' part | Amount |
|---|---|---|---|
| Cash | 20 | Money owed to suppliers (payables) | 20 |
| Money customers owe (receivables) | 30 | Bank loans | 80 |
| Stock of goods (inventory) | 25 | Equity (owners' part) | 100 |
| Buildings and equipment | 125 | ||
| Total assets | 200 | Total liabilities and equity | 200 |
So-what
The two sides always balance: assets equal liabilities plus equity.
Four ideas to know
- Working capital: money tied up in running the business day to day. In cases, people usually mean operating working capital: receivables plus inventory minus payables. The accounting definition is wider: all current assets minus all current liabilities.
- Capital spending (capex): money spent on long-lasting assets such as machines. It does not appear in the P&L all at once; it is spread over years as depreciation.
- Operating spending (opex): day-to-day costs such as salaries and rent, which appear in the P&L when they happen.
- Free cash flow: the cash left after running the business and paying for capital spending.
Worked case
Profitable, but short of cash
The prompt
A distributor in Mumbai made a net profit of INR 60 lakh this year, with depreciation of INR 20 lakh. Its customers now pay much later: receivables rose from INR 100 lakh to INR 300 lakh. It also holds more stock: inventory rose from INR 50 lakh to INR 120 lakh. What happened to its cash from operations?
The structure
- Cash from operations = profit + depreciation - increase in receivables - increase in inventory + increase in payables
- Add back depreciation: a cost, but no cash left the business
- Subtract money now waiting in receivables and stock
- Add any increase in payables (here payables did not change)
Working it through
1. Increase in receivables
From 100 to 300.
Increase in receivables (INR lakh):300 - 100 = 2002. Increase in inventory
From 50 to 120.
Increase in inventory (INR lakh):120 - 50 = 703. Cash from operations
Profit plus depreciation, minus both increases.
Cash from operations (INR lakh):60 + 20 - 200 - 70 = -190
The recommendation
Cash from operations was minus INR 190 lakh, even though the business made a profit of INR 60 lakh. This is because customers now pay much later, so receivables rose by INR 200 lakh, and inventory rose by INR 70 lakh, together far more than the INR 80 lakh of profit plus depreciation. The risk is that the business runs short of cash while it still reports profits. As a next step, collect from customers faster, starting with the largest late payers, and cut slow-moving stock.
A company has receivables of 40, inventory of 30, and payables of 25 (EUR millions). What is its working capital in EUR millions?
Assuming profit equals cash. Putting a large machine purchase entirely into one year's costs (it is capex, spread through depreciation). Forgetting that fast growth often needs more working capital, so growing companies can run short of cash.
Total assets are 500 and liabilities are 300. What is equity?
A company buys a new factory machine for 10 million that lasts 10 years. How does it usually show in the P&L?
Why can a fast-growing, profitable company run out of cash?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and frameworks
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