Reconnect to Lessons 02–03. Sarah shows profit and a balanced balance sheet — but her bank account is empty. Surface the friction point: profit does not equal cash.
The Cash Mystery: Profit Without Cash
Sarah walked into the bank feeling confident. Her Income Statement showed $4,220 in net income. Her Balance Sheet balanced perfectly. But when the loan officer asked, "How much cash did your business actually generate this month?" — Sarah froze. Her bank account had only grown by $800.
"I made $4,220 in profit," she said. The loan officer shook his head. "Profit is not the same as cash, Sarah. A business can be profitable and still run out of cash. We need to see your Statement of Cash Flows."
The Friction Point
Sarah stared at her two financial statements. The Income Statement told her she was profitable. The Balance Sheet showed her financial position. But neither one explained where her cash went. She needed a third statement — one that tracks actual cash movement.
"Did we make a profit?" — Revenues minus expenses. Uses accrual accounting, not cash.
"What do we own and owe?" — Assets, liabilities, and equity at a point in time.
"Where did our cash go?" — Actual cash in and out, organized by activity type.
Why Profit and Cash Are Different
Under accrual accounting, revenue is recorded when earned, not when cash is received. Expenses are recorded when incurred, not when cash is paid. This creates timing differences between reported profit and actual cash movement.
Sarah's Cash Clues
Accounts Receivable increased $2,100 — Sarah earned this revenue but has not collected the cash yet.
Supplies increased $400 — Sarah spent cash to buy supplies that have not been used yet.
Accounts Payable increased $600 — Sarah incurred expenses but has not yet paid cash for them.
Depreciation was $300 — This reduced net income but required no cash payment.
Why This Matters
Without a Cash Flow Statement, Sarah cannot explain to the bank why her profitable business has so little cash. Investors and lenders need to see that a business can generate actual cash — not just accounting profit. Today you will learn to build this third statement using the indirect method, starting from net income and adjusting for the differences between accrual and cash.
Today's challenge: Can you take Sarah's Income Statement and Balance Sheet data and build a Cash Flow Statement that explains exactly where her cash went — and convince the bank that her business is healthy?
1. Sarah's Income Statement shows $4,220 in net income this month. But when she checked her bank account, she only had $800 more than she started with. How is this possible?
2. Sarah's Accounts Receivable increased by $2,100 this month. What does this mean for her cash?
3. Which financial statement explains how a company's cash balance changed from the beginning to the end of a period?
4. A business reports $50,000 in net income but only $5,000 in cash from operations. Which explanation is most likely?
Phase 1 Learning Target
By the end of this phase, you should understand why net income does not equal cash flow, what timing differences cause the gap between profit and cash, and why the Statement of Cash Flows is essential for investors and lenders.