Profit is up. So why is cash down?

Here's the situation that confuses people. A company reports its best quarter ever. Net income is up 40%. And the cash balance fell. Nothing is wrong, nobody is committing fraud, and both numbers are correct.

The one idea underneath all of it

Net income is measured on an accrual basis. That means revenue is recorded when it's earned, not when the customer pays — and expenses are recorded when they're incurred, not when you write the check.

Cash is measured when money actually moves.

Those two timings are almost never the same. The gap between them is where "profitable but broke" lives — and it's why the cash flow statement exists at all.

Profit is an opinion about timing. Cash is a fact.

Where the money actually went

Start from net income and adjust it back toward reality. That's exactly what the top of the cash flow statement does:

Two adjustments are doing the work:

1. Depreciation and amortization

You bought equipment years ago and paid cash then. Accounting spreads that cost across the asset's useful life, so this year's income statement carries a depreciation expense — but no cash leaves the building this year. So you add it back. It reduced profit without touching cash.

2. Working capital — the usual culprit

This is what catches most people, and it's almost always the answer to "where did the cash go?"

• Accounts receivable went up. You made the sale and booked the revenue, but the customer hasn't paid yet. Profit rose; cash didn't.
• Inventory went up. You spent cash building or buying product that hasn't sold. Cash left; profit is untouched until it sells.
• Accounts payable went down. You paid off suppliers. Cash left, but the expense was recorded earlier.

Notice the pattern: growth consumes cash. A fast-growing company is constantly funding receivables and inventory ahead of collecting. That's why healthy, profitable companies fail — and why "profitable" and "solvent" are different questions.

The version your professor wants on the exam

When you're asked to explain the discrepancy, work through it in this order:

1. Timing: accrual accounting records revenue and expenses when earned or incurred, not when cash moves.
2. Non-cash charges: D&A reduced net income without a cash outflow, so add it back.
3. Working capital: increases in receivables and inventory consume cash; increases in payables provide it.
4. Conclusion: tie the specific driver to the specific number in front of you.

That fourth step is where most answers fall down. Don't recite the framework — point at the line item that actually moved.

The test of whether you've got it

Try this without looking anything up: a company's net income rises by $10 million, but cash from operations is flat. Give three plausible explanations.

If three come to mind quickly, you understand it. If not, that's exactly the kind of thing a session is for.