Profits aren’t cash

I’ve been reading a book I really like called Rebirth of American Industry and I intend to do a full blown review of it but for now, I wanted to mention the meat of the book’s discussion and how that ties into profitability for lean manufacturers. Briefly, the premise of the book is that Sloan type accounting in which inventory is included as an asset on balance sheets leads to many bankruptcies. As those of you who’ve kept up with lean discussion already know, inventory is the opposite of an asset; it’s waste. Inventory must be stored, managed and worse, it depreciates. Inventory is a waste that lean producers can ill afford. Lean manufacturing succinctly states that you first produce prototypes, you sell from them and then you produce based on your orders taken. Anyway, I thought to mention all this because my bank (Wells Fargo) has discovered that inventory isn’t necessarily an asset and should not be confused with profitability.

In the January 2006 issue of Wells Fargo Small Business Roundup newsletter, we wrote about the importance of cash flow. Within the scope of cash flow, it can sometimes be easy to equate profits with cash, but that can be a mistake. Companies can, and do, go broke while making profits. If all your cash is tied up in inventory and accounts receivable, for example, you can be broke and profitable at the same time. And you can’t pay bills with profits.

You can read more at Why Profits Aren’t Cash. If this link doesn’t work for you let me know and I’ll see if I can get permission to reprint the article.

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  1. Bill Waddell says:

    Thanks for the kind words about the book Kathleen.

    When asked what the Toyota Syatem was, Taichi Ohno said, “All we are doing is looking at the time line, from the moment the customer gives us an order to the point when we collect the cash. And we are reducing the time line by reducing the non-value adding wastes.” He could not have made it any plainer that lean is all about cash flow.

  2. Joe Ely says:

    Preach it, Kathleen!!!

    You are so right. And this is so misunderstood. Bill does a great job at continually hammering this fact.

    Profits are a result of assumptions. About allocated costs, depreciation schedules, probability of collecting debts, yield on inventory, etc etc.

    Cash is reality. What comes in has to be greater than what goes out.

    Thus, cash flow is a better measure of our real results than profitability. This offends the accountants, yet is real.

    For entrepreneurs, it is even more crucial. Cash is the life blood. Profits are an illusion.

    And Lean provides a proven method of freeing up cash.

  3. Mike C says:

    Entrepreneurs need to understand the basics of accounting. At the heart of every “profitable” company that’s gone bankrupt is either a) a misunderstanding of what working capital is and how much is needed or b) fraud.

    Cash flow statements are nice, but they can be manipulated to achieve short term results and can mask underlying problems with a business just as a P&L can.

    There are great moral hazards involved with how business account for their activities
    and smart entrepreneurs need to realize that their financial statements (*all of them*) need to reflect the reality of their business rather than be goals in and of themselves.

  4. Bill Waddell says:

    Mike’s comment is certainly valid so long as we can be sure to include the caveat that a standard, GAAP approved, IRS and SEC approved balance sheet that includes inventory as an asset does not reflect the ‘reality of the business’. The terms “asset” and “waste” are antonyms – opposites. Every lean principle is built around the fundamental point that inventory is waste – and that cannot co-exist or be rationalized with calling inventory an asset on a balance sheet.

  5. Mike C says:

    It goes back to understanding the basics of accounting.

    Accountants do not recommend that you boost the amount of inventory that you carry because its an “asset” any more than they recommend boosting your “receivables” asset by asking customers to delay their payments to you.

    Accountants recommend keeping both inventory and receivables to the minimum possible. They don’t ascribe “good to have” as part of the general definition of assets.

  6. Bill Waddell says:

    … but the accountants do say that you can overbuild and create inventory, take overhead expenses off of the P&L and put them on the balance sheet in the assets column, and look more profitable. And conversely, they say that if you get lean and cut inventory in half, there will be a severe hit on the P&L when all of that old overhead comes back off the balance sheet and hits the bottom line. Accountants are not that innocent, Mike, when they run a system that says building inventory is profitable and reducing inventory is unprofitable. Worse, they mislead management into thinking that absorption accounting and the matching principle are the only way to comply with the SEC, SOX and the rest and therefore act as the number one hindrance to American manufacturing becoming lean.

    The problem is not that manufacturng does not understand the basics of accounting, Mike. It is that accounting does not understand the basics of manufaturing. The only aspect of manufacturing that has not changed in response to the new global and technology realities is accounting. They still send management into a battle for survival with the hand Donaldson Brown dealt them in 1923.

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