Understanding the difference between

a profit and loss statement and a cash flow statement

Let us look at the following examples:-

1) A man trying to swim across a flooded river to grab a huge prize promised to him for doing the feat.

2) A person going hungry for 100 days to win a competition.

3) An employer promising his employee 24 times his monthly salary for a job. But the only catch being that the salary would be paid together at the end of the first year.

4) An organization spends a large sum of money in a brand campaign but does not have enough money left to pay the salaries of the employees.

5) A man buying the best car available but running out of money to buy fuel.

6) A person getting admitted into the best university but having money that would only fund half the course.

In the all the above examples, we have seen that somewhere there dangles an appetizing proposition but the path that is drawn up to make it to the goal is fraught with danger. For example, the man who is crossing the river has little probability to survive till the other end. If he cannot make it, then what is the use of the grand prize?

Similarly, the person going hungry for 100 days may not live to enjoy the fruits of his perseverance. The employer who promises double salary to the employee takes the thunder away when he places the condition before him that he'll get paid only at the end of the year. How would the employee survive the year without being paid?

Likewise, buying a great car but having little left to maintain and run it becomes a futile and meaningless act and so also would be the case when a person goes to the best university only to realize that he does not have enough to fund the entire course. An incomplete course, quite obviously has little value. There is no logical concept like half a doctor or half an engineer or three fourths a lawyer. You are either a professional or you are not.

The above examples have been explained to help one understand the difference between the Profit and Loss Statement and Cash Flow statement. While the profit and loss statement gives an indication of the operational efficiency of a business, it does not entirely reflect the cash flow of the business.

For example, if you are a sculpture and you invest 10K in materials to sculpt statues. You then sell those to a client for 20K, and make a profit of 10 K. In the P/L statement, you would record this 10 K profit even though you haven't received the money. Now the client may take up to an “X” number of days to pay you. This is one of the main differences between a P/L statement and Cash Flow statement. The P/L statement uses accrual accounting. This is when all revenues are recorded when earned, and expenses when incurred.

Now, in your sculpting business, the company may get a huge order and spend a lot of money in supplying the goods on credit, and this as a result would leave the company with inadequate amount of money for salaries. So even if the business opportunity is large, organizations should know how to manage their money. They have to understand that paying employees on time and maintenance of machines need to be given priority over simply chasing orders. This is why the cash flow statement is a reflection of a company's health, whether it is able to pay bills on time and its ability to finance growth. Simply looking at the P/L statement may not give the kind of insights, However, a P/L statement shows a thorough account of revenues and expenses and is helpful for a person to gauge the earnings per share and whether to invest in a company or not.

In the end, it is important to look at both of these statements together to get a better understanding of how the business is doing as a whole. Each statement gives vital information, and they work hand in hand. If the net income is low on the P/L statement, then invariably there is a weak cash flow and one will be able to see where the cash is being spent on the cash flow statement. Looking at these statements separately and drawing conclusions will only leave you will half the piece of the pie and leave you in situations like the ones mentioned above.

I hope this helped clarify the different between the P/L statement and Cash Flow statement.

Disclaimer: The views expressed in this lesson are for information purposes only and do not construe to be any investment, legal or

taxation advice. The contents are topical in nature and held true at the time of creation of the lesson. This is not indicative of future

market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at

your own risk. Tata Asset Management Ltd. will not be liable for the consequences of such action.

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