Profit vs. cash, and how accrual accounting works
A company can report a healthy profit and still be short of cash, or sit on a mountain of cash while reporting a loss. The reason is accrual accounting. Once you see how it works, the rest of financial analysis gets much easier.
The one idea this module rests on
Profit measures whether a company sold its products for more than they cost. Cash measures what is actually in the bank. They are related, but they are not the same thing, and they almost never move together in the short run.
Imagine you run a small furniture workshop. In September you build and deliver a custom table for $1,000. The customer says they will pay in November. You also paid your lumber supplier $300 in August for the wood, and your assistant $200 in September for the labor.
When did you earn your profit? Most people would say September, when you finished and handed over the table. That instinct is exactly what accrual accounting formalizes: record revenue when it is earned and expenses when they are incurred, regardless of when the cash actually moves. So your September income statement shows $1,000 of revenue, $500 of expense, and $500 of profit, even though no customer cash has arrived yet.
Now look at your bank account. In August it fell by $300 (the wood). In September it fell by another $200 (the labor) and rose by nothing, because the customer has not paid. Your cash is down $500 in the very month your income statement says you made $500. The $1,000 you are owed is real, but it is sitting in an account called accounts receivable, not in the bank.
That gap between earning and collecting, and the matching gap between incurring a cost and paying it, is where four everyday accounts come from. They are the plumbing of accrual accounting, and they appear on almost every balance sheet you will ever read.
The four timing accounts
Whenever cash and the accrual event happen at different times, the balance sheet records the difference so nothing is lost. There are exactly four cases: a sale where cash comes later, a sale where cash came earlier, a cost where cash comes later, and a cost where cash came earlier.
You delivered and earned the revenue, but the customer has not paid yet. The company is owed cash.
AssetYou received goods or services and recorded the expense, but have not paid the supplier yet. The company owes cash.
LiabilityThe customer paid up front, but you have not delivered yet. You still owe them the product, so it is not revenue yet.
LiabilityYou paid in advance, say a year of insurance, but have not used the benefit yet. It becomes an expense gradually.
AssetTwo of these are assets (someone owes you, or you paid ahead) and two are liabilities (you owe someone, or you were paid ahead). Notice the symmetry: a deferred revenue on one company's books is just a prepaid expense on its customer's books. The same cash, seen from two sides.
Accrual accounting follows the matching principle: report the cost of a sale in the same period as the sale itself, so each period's profit reflects real effort and reward rather than the accident of when cash happened to move. Cash basis accounting, which records only when money changes hands, is simpler but can make a great month look terrible and a terrible month look great. That is why public companies are required to use accrual accounting under GAAP.
So how do you get from profit back to cash?
Because profit and cash differ, every company also publishes a cash flow statement that starts from net income and adjusts it back to real cash. The logic is short. Add back costs that reduced profit but never used cash, and subtract the cash that got tied up in those timing accounts.
Non-cash charges are things like depreciation and stock-based compensation, which lower profit on paper without a cash payment. means "the change in." If receivables rise, cash is tied up, so it is subtracted.
The single most useful instinct in this whole course is this: when accounts receivable rises, the company booked revenue it has not collected, so cash is lower than profit. When a payable or deferred revenue rises, the company is holding cash it has not yet spent or earned, so cash is higher than profit.
This bridge from profit back to cash is also where valuation begins. The cash from operations formula above is the start of free cash flow, and free cash flow is what a discounted cash flow model discounts to value a company, the DCF you build in Module 12. The very first idea in this course, that profit is not cash, is the thing a valuation ultimately rests on.
Worked example: Apple, fiscal 2024
Apple is a useful first example because the gap between its profit and its cash is large and easy to explain. Here are the figures that matter for this module, taken directly from Apple's fiscal 2024 10-K.
| Total net sales (revenue) | 391,035 |
| Net income (profit) | 93,736 |
| Cash generated by operating activities | 118,254 |
| Accounts receivable, net | 33,410 |
| Accounts payable | 68,960 |
| Deferred revenue (current) | 8,249 |
Look at the two highlighted lines. Apple's net income was 93,736, but the cash it actually generated from running its business was 118,254, almost $24.5 billion more. A beginner might expect profit to be the bigger, more impressive number. Here cash is far larger. Why?
Because a chunk of Apple's reported expenses never used any cash this year. The two biggest are depreciation and amortization of 11,445 (the wearing down of equipment Apple already paid for in earlier years) and stock-based compensation of 11,688 (employees paid in shares, not cash). Add those back, along with a small net contribution from the working-capital accounts, and you bridge from profit to cash.
The timing accounts are visible too. Apple was carrying 33,410 of accounts receivable, revenue it had earned but not yet collected. On the other side, it owed suppliers 68,960 in accounts payable, and it held 8,249 of deferred revenue, cash collected for services like AppleCare and iCloud that it still has to deliver over time. Each of those is a place where cash and profit part ways.
Another example Microsoft, same idea, second dataset
Microsoft shows the same pattern even more dramatically, because so much of its business is paid for in advance. In fiscal 2024 Microsoft reported net income of 88,136 but generated 118,548 of cash from operations, a gap of more than $30 billion.
| Total revenue | 245,122 |
| Net income | 88,136 |
| Net cash from operations | 118,548 |
| Short-term unearned (deferred) revenue | 57,582 |
| Accounts receivable, net | 56,924 |
Notice the 57,582 of unearned revenue. That is over $57 billion customers have already paid Microsoft for cloud and software subscriptions that it will deliver in future periods. The cash is in the bank now, but it is a liability, not revenue, until the service is provided. This is a major reason Microsoft's cash runs well ahead of its accounting profit.
Treating net income as money in the bank. Net income is an accrual figure. It includes sales not yet collected and excludes large cash outlays like buying equipment or repaying debt. To see real cash, always go to the cash flow statement.
Watch for net income rising while cash from operations falls, especially when accounts receivable is growing faster than sales. It can mean a company is booking revenue aggressively or struggling to collect from customers. We return to this signal in Module 15, Quality of earnings.
Practice
Work each one out yourself before revealing the answer. Computing by hand is how this becomes second nature.
Bridge Apple's profit to its cash. Start from net income, add the two non-cash charges and the remaining adjustments below. What is cash from operations?
| Net income | 93,736 |
| + Depreciation & amortization | 11,445 |
| + Stock-based compensation | 11,688 |
| + Other items and change in working capital | 1,385 |
Correct. That is Apple's reported cash from operations.
Not quite. Add the four lines together, then check the steps.
Worked solution
- Add back the non-cash charges to net income: 93,736 + 11,445 + 11,688 = 116,869.
- Add the remaining adjustments: 116,869 + 1,385 = 118,254.
- Cash from operations is 118,254, about $24.5 billion above net income, almost all of it from the non-cash add-backs.
A software company ships a product and emails the license to the customer in December. The customer pays the invoice in January. Under accrual accounting, in which month is the revenue recognized?
Correct.
Look again at when the company earned the revenue.
Why
- Revenue is recognized when it is earned, which is when the product is delivered in December.
- The January cash simply collects a December receivable. It does not create new revenue.
A gym collects $1,200 from a member in January for a full year of membership. As of January, what kind of account does that $1,200 create on the gym's balance sheet? Name the account.
Correct. It is deferred (unearned) revenue, a liability.
Think about whether the gym has delivered the service yet. Try "deferred revenue".
Worked solution
- The gym has the cash but has not delivered eleven of the twelve months of service.
- It still owes that service, so the amount is deferred revenue, also called unearned revenue, a liability.
- Each month, one twelfth ($100) moves from the liability into revenue as it is earned.
Apple's accounts receivable rose over the year as shown below. All else equal, how much cash did that increase tie up (use) during the year?
| Accounts receivable, start of year (FY2023) | 29,508 |
| Accounts receivable, end of year (FY2024) | 33,410 |
Correct. A rising receivable is a use of cash.
Subtract the start from the end. A rise in receivables uses cash.
Worked solution
- Change in receivables: 33,410 − 29,508 = 3,902.
- Receivables went up, which means Apple booked $3,902 million of revenue it had not yet collected in cash.
- Using −ΔAR, the cash effect is −3,902, a use of $3,902 million of cash.
Microsoft is carrying $57,582 million of unearned revenue. On the balance sheet, this is best described as which of the following?
Correct.
The cash is real, but has Microsoft delivered the service yet?
Why
- Customers paid in advance, but Microsoft has not delivered the future service yet.
- Because it still owes that service, the amount is a liability. It converts to revenue only as the service is provided.
Memorize
Flip each card, then mark whether you have it. Cards you miss come back sooner.
Profit is earned; cash is collected. Accrual accounting records revenue when earned and expenses when incurred. The four timing accounts, receivables, payables, deferred revenue, and prepaids, are simply where cash and profit differ in time. To see real cash, read the cash flow statement, which adds non-cash charges back to net income.