How Can a Profitable Business Run Out of Cash? (2024)

How Can a Profitable Business Run Out of Cash?

Even a profitable business can run out of cash if it does not effectively manage its cash flow. Profitability, as measured by net income on an income statement, is not the same as cash flow, which is the inflow and outflow of cash in a business. Here are a few scenarios where a profitable business could run out of cash:

• Accounts Receivable: If a business generates its revenue through credit sales, the profit will be recognized on the income statement when the sale is made, not when the cash is received. If customers delay payments or default on their invoices, the company may be profitable on paper but lack the cash inflow it needs to operate.
• Inventory Management: If a company has a lot of its cash tied up in inventory that it can’t sell quickly, it might run short of cash for other operating needs.
• Large Capital Expenditures: If a business makes significant investments in long-term assets (such as property, plant, and equipment), the company may be left with little cash for other uses. The profits from these investments may not materialize until much later when the assets are put into use.
• Debt Repayments: A business may be making a profit but have high debt repayments. If a significant portion of its cash flow is used to pay off debts, the company might struggle with day-to-day operational expenses.
• Operating Expenses: High operating expenses, such as rent, salaries, utilities, or marketing costs, can deplete cash rapidly, leaving a profitable business cash poor.
• Dividend Payments : If a company decides to distribute a large portion of its earnings as dividends to shareholders, it may find itself short on cash for its operations.
• Seasonal Variations: Some businesses have seasonal revenue streams. They might be profitable overall, but during off-peak seasons, they could run out of cash.

For these reasons, it’s crucial for businesses to manage not just profitability, but also cash flow. This is often done through good working capital management, careful planning of capital expenditures, and prudent debt management.

Example of How a Profitable Business Run Out of Cash

Let’s consider a fictional manufacturing company, “Crafty Carpentry,” which produces high-end custom furniture.

Crafty Carpentry is profitable on paper, reporting a solid net income in its income statement. They make substantial sales, but most of these are on credit terms with their customers who have up to 60 days to pay. This means that while their income statement shows healthy profits, the actual cash from many of these sales isn’t received immediately, leading to a high amount in accounts receivable.

Simultaneously, Crafty Carpentry’s suppliers require payment for raw materials within 30 days (accounts payable). Also, the company has taken on a significant amount of debt to invest in new equipment and must make regular, substantial loan repayments.

Additionally, Crafty Carpentry holds a large amount of inventory to be ready for custom orders, tying up cash in stored goods.

Here’s what happens: While Crafty Carpentry is selling lots of furniture (profitable on paper), there’s a time lag before they receive cash from their customers. However, they have to pay their suppliers and loan repayments more immediately. Plus, they have a significant amount of cash tied up in unsold inventory. All these factors lead to a cash crunch, despite their profitable status.

In this situation, Crafty Carpentry might struggle to cover its day-to-day operating expenses, potentially leading to financial difficulty despite the reported profits. To alleviate this, the company needs to manage its cash flow effectively, possibly by improving its inventory management, renegotiating supplier terms, or incentivizing quicker payments from customers.