How misreading cash flow can hurt startups

One of the biggest misconceptions in finance for early stage companies is to consider that being profitable (or not) is the same as generating cash (or not).

Profitability means generating net income (greater than zero) over a given period. Being cash flow positive, on the other hand, refers to an increase in cash and cash equivalents during that time. 

This confusion often arises from the assumption that EBITDA is a reliable proxy for free cash flow —which is only partially true. To illustrate this point, a company that is repaying debt would have its cash flow impacted by the interests that are being paid on the debt. Also, if the company has to pay income tax, cash flow would again differ significantly from EBITDA (it is true that depreciation and amortization should not impact cash).

Other than that, it is important to note that the income statements (statement used to assess profitability), are prepared on an accrual basis, whilst the cash (and cash equivalent) balance considers what actually goes through the account (ie, entries based on cash statement dates). 

To illustrate, picture a company that collects payments for services rendered three days after month end. In terms of profitability, the revenue is included on the month it rendered services (eg, December) but cash will only be seen in January. So one could say that it was profitable in December and was cash flow negative (if we assume that expenses were all paid in December). But in that case, the company was only cash flow positive in January.

Indeed, month-end cut-offs can make this distinction even more complex and are a common source of confusion.

For that reason, it’s essential to distinguish between the two concepts and understand which metrics your stakeholders care about most. On a side note, this also represents why it is more valuable to analyse P&L / Cash over a certain period of time, instead of on a monthly basis, only.