Why do profitable companies run out of cash?

A company that reports a profit at year end and then struggles to pay salaries the same month looks, from the outside, like a contradiction. It is not. It is two different answers to two different questions. The income statement answers “how much value did we create this period?” The cash flow answers “how much of that value reached the bank, and when?”

Accounting works on an accrual basis. A sale is recorded as revenue when it is invoiced; the fact that payment will arrive three months later does not change that entry. Likewise, inventory is an asset rather than an expense until it is sold, even though it may have been paid for long ago. Most of the distance between profit and cash lives in these timing differences.

Working capital: where profit waits

The concept that best explains the distance between profit and cash is working capital. In simplified form:

• Trade receivables: revenue that has been earned but not yet collected.
• Inventories: goods that have been paid for but not yet sold.
• Trade payables: goods and services received but not yet paid for.

Receivables and inventory tie up cash; payables release it. Every increase in the sum of these three items means part of the profit on the income statement has gone onto the balance sheet rather than into the bank.

Growth consumes cash

This mechanism becomes most visible in growing companies. As sales rise, receivables and inventory rise with them. If longer payment terms were offered to win that growth, the increase accelerates.

The table below shows two years of a hypothetical company. Sales grow by 40 per cent, the profit margin holds, and net profit rises. But days sales outstanding lengthen from 60 to 75, and days in inventory from 45 to 55.¹

In Year 2 the company reports a profit of TRY 11.2 million, yet because TRY 14.8 million is absorbed by working capital, its operations consume TRY 3.6 million of cash. The company is more profitable — and poorer.

Nothing in this example is wrong. The sales are real, the profit is real, and the receivables will most likely be collected. The problem is that until they are, salaries, taxes, rent and loan instalments keep falling due.

Tax sees profit before collection

In Turkey, tax makes the effect sharper. VAT arising on an invoice is declared and paid in the following period even if the customer has not yet paid. Taxes on profit are likewise calculated on accrued profit, not on cash collected.

A company that sells on credit therefore finances, out of its own cash, the tax on revenue it has not yet received. Treating tax payments as “something to look at later” in cash planning can make the squeeze land in exactly the tightest week.²

What can be done?

There is no single solution, but there are clear ways to make the risk visible. I have also collected them as a framework on the cash flow management page.

Track cash weekly. A monthly budget is too coarse to catch a cash squeeze. The problem usually forms within a month, in specific weeks. A thirteen-week cash projection — starting from opening cash and spreading collections and payments across the weeks — shows the critical weeks in advance.

Put working capital indicators in the management report. Days sales outstanding, days in inventory and days payable outstanding, together with the cash conversion cycle that combines them, deserve as much attention as the profit margin.

Assess growth decisions together with their cash requirement. The cash a new customer or market will tie up in working capital should be calculated alongside the profit it will bring. Some growth opportunities weaken a company if their financing is not planned in advance.

Talk about financing before you need it. A conversation with the bank when cash is already tight does not end the same way as one held three months earlier, with a projection on the table.

Conclusion

Profit shows whether a company is on the right economic path. Cash shows whether it can keep walking that path. One does not substitute for the other. Good financial management means reading the income statement with the balance sheet in mind — and the balance sheet with the coming weeks’ cash in mind.

Sources

• Turkish VAT Law No. 3065 — Mevzuat Bilgi Sistemi (in Turkish)
• Turkish Revenue Administration (GİB)

Notes

1. The example is simplified: depreciation, capital expenditure, finance costs and the timing of tax payments are ignored. Figures are rounded. ↩

2. The timing of VAT, provisional tax and social security payments should be assessed separately in light of the company’s activities and current legislation. ↩