Why Earnings and Cash Differ

Why this matters

This lesson is optional. Headlines quote earnings, but bills are paid with cash. STU Corp earned $58 million this year and generated $84 million of operating cash, and those two numbers are rarely the same for any company. Usually the gap has ordinary explanations. Occasionally it's the first sign that reported profits are weaker than they look.

Accrual accounting

Financial statements use accrual accounting. The FASB, which sets US accounting standards, describes it as recording the effects of transactions in the periods when they happen, even if the related cash is received or paid in a different period. Its reasoning is that this gives a better picture of a company's performance than a simple record of cash in and out.¹ Revenue, for example, is recorded when a company delivers the goods or services it promised, in the amount it expects to be paid, not when the payment arrives.²

Four reasons profit and cash differ

1. Timing. Customers pay later, inventory is bought before it's sold, bills are paid after the cost is recorded, and subscribers pay in advance. These show up in receivables, inventory, payables, and deferred revenue.
2. Long-term spending. Equipment is paid for up front but expensed gradually, through depreciation. In a year of heavy investment, cash goes out far faster than the expense.
3. Costs paid in shares. Accounting rules require companies to record pay given in stock and options as an expense, measured at fair value.³ No cash leaves, so the cash flow statement adds it back. The cost is real, though: it's paid by existing owners through dilution, as Dilution and Stock Splits showed.
4. One-time items. A gain from selling a building, a write-down of an asset that lost value, or the cost of closing a plant can push one year's profit up or down. These often involve little cash in that year, and they don't say much about the years ahead.