Profit is not cash
Many business owners ask: “The statements say we made a profit, so why isn't the balance enough to pay salaries?” The answer lies in the statement of cash flows, the only statement that tracks the actual cash coming in and going out.
Profit is calculated on the accrual basis: a credit sale not yet collected counts as profit, goods bought and paid for are not counted as an expense until they are sold, and depreciation is an expense with no cash outflow. That is why profit and cash can drift far apart.
The three sections
- Operating activities: cash from day-to-day operations: collections from customers, and payments to suppliers, salaries, expenses and Zakat.
- Investing activities: buying and selling long-term assets such as equipment, vehicles and property.
- Financing activities: loans and their repayment, capital, and dividends or drawings.
Under the indirect method, which is the most widely used, we start with profit and then adjust it for non-cash items and for the change in working capital.
Solved example
A food distribution company made a net profit of 400,000 SAR in 2025. From the statements of financial position for the two years:
- Depreciation for the year was 60,000 SAR.
- Accounts receivable rose from 250,000 to 600,000 (an increase of 350,000) after expanding credit sales to retail stores.
- Inventory rose from 300,000 to 550,000 (an increase of 250,000).
- Accounts payable rose from 200,000 to 280,000 (an increase of 80,000).
- A refrigerated truck was bought for 200,000 in cash.
- A bank loan of 150,000 was obtained, and partners' drawings were 100,000.
- Cash at the beginning of the year was 300,000.
| Item | Amount (SAR) |
|---|---|
| Cash flows from operating activities | |
| Net profit | 400,000 |
| Add: depreciation | 60,000 |
| Increase in accounts receivable | (350,000) |
| Increase in inventory | (250,000) |
| Increase in accounts payable | 80,000 |
| Net cash from operating activities | (60,000) |
| Cash flows from investing activities | |
| Purchase of a truck | (200,000) |
| Net cash from investing activities | (200,000) |
| Cash flows from financing activities | |
| Bank loan | 150,000 |
| Partners' drawings | (100,000) |
| Net cash from financing activities | 50,000 |
| Net change in cash | (210,000) |
| Cash at beginning of year | 300,000 |
| Cash at end of year | 90,000 |
Why do we add and subtract like this?
- Depreciation is added back because it was deducted from profit without any cash going out.
- An increase in current assets is subtracted: an increase in receivables means sales that entered profit but whose cash has not come in, and an increase in inventory means cash paid for goods that have not yet reached cost of sales.
- An increase in current liabilities is added: an increase in payables means goods the business received but has not yet paid for, so it is temporary financing.
The reverse is also true: a decrease in receivables or inventory is added, and a decrease in payables is subtracted.
What does the statement tell the owner?
The company is profitable, but operating activities consumed 60,000 SAR instead of generating cash. The main cause is not weak profitability but working capital: 600,000 SAR went into customer debts and additional inventory. Then the company bought a truck and the partners drew 100,000, so the loan did not cover the gap.
The logical solutions here: tighten credit terms and monitor debt ageing, reduce slow-moving inventory, negotiate longer payment terms with suppliers, and postpone drawings until liquidity improves.
Checking the statement
Before approving the statement of cash flows, carry out three quick tests:
- Closing cash: it must equal the cash and cash equivalents balance in the statement of financial position at year end. In our example, 90,000 SAR.
- Movement in fixed assets: opening net fixed assets + purchases - depreciation - net book value of disposals = closing net fixed assets. If the equation does not hold, there is an investing transaction that has not been shown.
- Movement in equity: opening retained earnings + net profit - dividends or drawings = closing balance. This is where the drawings amount presented under financing activities shows up.
Also watch for non-cash transactions, such as buying an asset with a loan directly from the seller, or converting a partner's balance into capital. These do not appear in the statement itself because they did not move cash, but they are disclosed in the notes to the financial statements. And in businesses registered for VAT, remember that the change in the VAT payable balance is also part of working capital, and is treated like accounts payable: an increase is added and a decrease is subtracted.