Cash or Profit: What Is More Important - Essay Example

CASH OR PROFIT – WHAT IS MORE IMPORTANT? and Section # of Cash or profit – which is more important for an organization? Introduction: Profit and cash are two extremely important objects in the business arena- they are the reason for which people come into the business arena; to earn money and make profits. The basic purpose of starting a business is to gain money. When a person feels that they can pool in resources of a certain value to produce something of a greater value, they work towards the achievement of the goal, thus forming a business chain. The debate whether cash or profit is more important to the business is relative- depending on which field of the business we are concerned about. The distinction between cash and profit has come in due to the increasing use of credit sells that are done in the business arena. Doing business on credit is the backbone of the biggest economies today; the financial system in the whole world is built upon credit transactions. Credit transactions help in making a transaction without actually having to pay cash at the time of transaction; a sale is recognized, profit considered. Selling on credit does bring in profit, however, fails to bring in the cash in a certain period or quarter. This essay discusses the importance of each of the objects and the difference that is present between the two objects. After covering the basics about cash and profit, the relative and absolute importance is discussed, followed by a conclusion. Cash and profit: To start from scratch, the basic difference between the two objects of discussion should be made. Research has showed that the distinction between the two is not as clear as it should be for the common man, as well as managers working in the business arena. This is a shocking revelation made by Harvard Business Review in a factoid, claiming that a majority of managers in the United States fail to distinguish between profit and cash. The factoid further claims that a large number did not know the difference between the income statement and balance sheet, the two most important financial documents for managers of any organization (Sean, 2009). To quote directly from the HBR Article, an average of 38% was scored by corporate level executives as well as supervisors, on a financial literacy test (Karen, 2009). Financial literacy, especially the basics are highly important for a manager working in any field; a lack of knowledge will definitely hurt the organization they are working for in one way or the other. Starting from the basics, cash is the actual money that an organization possesses, in its bank account. For simplicity purposes, we will discuss cash flow rather than cash- to acquaint the readers with the importance of cash. Cash flow is the money flowing in and out of an organization. This flow may be from operations, or financial activities or investing activities. The cash flow statement is developed to understand the direction of the cash flow in an organization in a given period of time. Profit, on the other hand, is the difference between the revenues and expenses of an organization. In a hypothetical simple situation, where there are no accruals or credit sells and buys, they may not be any difference between the cash that an organization owns after a certain period and its profit for the same period. However, in real life- things get complicated (James, 2007). According to the revenue recognition principle in accounting, it is required to recognize revenue in the same period it was generated, whether or not the cash payment for such a transaction was done or not. So, for example, if a small business sells their basic products on cash as well as credit cards on the 29th of December; the revenue that will be recognized for that day will be the total of the cash that was received AND the sales which were made on credit through the credit card. The payment of the credit sales will be received much later; this payment may be received on the 3rd of January. As of 31st December, the profit of the organization will be more than the cash that is owns. This is the reason that organization can pay make a profit but still have a negative cash flow; as the revenue that was made of credit does not mean money came into the system in the same time period. There is a big chunk of organizations, which go bankrupt because they fail to understand the fundamental difference and the importance of cash in an organization. Cash and profit are both very important for an organization. However, relatively speaking, the health of an organization is judged by the cash flow management in that organization. A company can go on for a longer period of time with negative profits, but a negative cash flow means serious issues. Cash flow shows a real picture of how the money is going in and out of an organization. The real flow of cash through an organization can tell a lot about the health of an organization, its ability of paying its future commitments such as paying its employees, loans etc. Therefore, if the company has positive cash flow it shows a greater capability to meet future obligations (Rosemary, 2010). If a company is showing a negative cash flow- meaning more cash is going out of the company then coming in, it is in trouble. According to the accrual based accounting, profits may be recorded on accrued basis, but the actual recovery of the money may be done well later than the stipulated time. This may bring a downfall of an organization in months. As accruals increase, leading to negative cash flows, the company may still have to pay its employees and carry out the monthly operations. The company may have to shut down if the recovery of the accruals is not made on time. In short, an organization can show a million dollar profit in a month, but may go bankrupt the next month, due to poor cash management (William, 2003). In absolute terms, both cash and profit are tremendously important for an organization. If the company is not making a profit, it means the expenses that are being incurred in the production and operation of a good or a service, are more than the return they are generating. The model that the business is working on is not successful. If this continues for a long time, the owner has to pump in more money till the business can sustain and the negative profits change into positive. Cash flowing in the organization is the best thing that can happen to it. Too much of cash reserves with an organization mean the asset is not being utilized properly; however, a proper cash level should be maintained at all times, so that in a crisis, the organization can reach out to its reserve to save itself (Carl, 2008). On a relative basis, and in real life – there are ample examples around us to realize that cash flow has a higher importance than profits for the health of an organization and its long term strategic growth. This is especially important for small companies and businesses; they may be making a profit but be unable to pay their bills. However, it is not so that the organization does not care about its profits at all – the point being made is that profit making should not be the entire focus of the management. A proper cash flow management team should also be set up; guiding the organization with the policies that make sure cash management is done properly in an organization (John, 2009). Conclusion: All in all, both cash and profit are important for an organization. Without making profits, the company may go bankrupt as the losses show the business model is not working. If the company is making profits, with a big proportion on credit, it is again on a risk of bankruptcy by not being able to recover their money from customers and being unable to pay their future obligations. Therefore, cash holds a relatively higher importance than profits – neither of them should be taken lightly in business. References Albrecht, W., Stice, J. et al. (2007). Accounting: Concepts and Applications. Cengage Learning Wildman, J. (2009). Principles of Accounting. Bibliobazaar Warren, C., Reeve, J. (2008). Accounting. Cengage Learning Webster, W. (2003). Accounting for Managers. McGraw Hill Professional Harvard Business Review/Karen Berman, Joe Knight. (October, 2009). Are your people financially literate? Retrieved December 2, 2010, from http://hbr.org/2009/10/are-your-people-financially-literate/ar/1?cm_mmc=npv-_-DAILY_STAT-_-NOV_2009-_-STAT1105 Bnet/Sean Silverthorne. (2009, November 5). You know the difference between cash and profit. Right? Retrieved December 2, 2010, from http://www.bnet.com/blog/harvard/you-know-the-difference-between-cash-and-profit-right/4407 Read More