When talking about business you’ll often here “its all about the bottom line”
Do you know what the “bottom line” is ?
The Bottom line refers to the Net Profit line on the Income Statement (also known as the Statement of Comprehensive Income or the Profit and Loss Statement). And it is literally the bottom line as its found at the bottom of this statement.
This is the profit the business has earned and you calculate it by subtracting all the expenses from the income.
Here’s an example showing the 2017 Statement of Comprehensive Income for Shoprite
So if your business is making profits does this mean that everything is fine ?
The answer is no.
Let’s look at why.
Firstly, net profit is not the same as cash coming into the business. A business can generate large profits and still experience cash flow problems.
What you must understand is that net profit is NOT the same as cash flow.
If you have made profits it means that you have increased the amount of net assets in your business (provided you haven’t taken it out of the business via dividends). Your business has become more valuable in accounting terms.
However, this increase in business value isn’t necessarily in the form of cash. It could be an increase in the amount of inventory (i.e. stock), debtors or other assets.
This means you can easily have a situation where your net assets have gone up (i.e. you made a profit) but you have less cash. In this instance, your profit is sitting in stock, debtors or other assets.
While profit is very important, we still need to turn those profits into cash.
So, in addition to Net Profit we also need to look at whether the business is generating enough cash.
For this, we look at the Operating Cash Flows of the business. This is a measure that tells us whether the operations of the business are generating cash or using up cash.
So if we have good profits and also good operating cash flows it means that we are converting our profits into cash.
When big businesses commit accounting fraud they can often inflate the net profit number on their Income Statement.
However, while the net profit can be manipulated its not easy to lie about cash flow. So when a business is showing really good profits over time but the operating cash flows are not good that is a red flag. This doesn’t always mean that some fraud is occurring as there are legitimate reasons for good profits but poor cash flow (which we cover in our course) but it is certainly a warning sign.
OK, so lets say you have a business with good profits and good operating cash flow.