Question

The following is a quote from the textbook "You can be very profitable and still go out of business". Do you agree with this quote? Why or why not? Explain your answer.

Answer 1

You can be very profitable and still go out of business:

In a business, cash is king. Even if a business in on net profit on paper but it doesn't have enough cash to pay for its bills then the business couldn't sustain and it will definitely go out of business even after being profitable. This is because for a business, Cash flow and profitability are two different facets dealt with different accounting rules. And each has its role in keeping the business afloat.

Consider a case when a company has a sales of $1000 in a month in which it gets a net profit of $400. But 50% of this sales is done of credit. Which means, the company will receive $ 200 of net profit  in next few months and it is accounted as accounts receivable. In this same month, the company has incurred expenses worth $300. Now due to sales on credit, we find that the company doesn't have enough cash to pay for its expenses of $300 incurred in this month.

Now consider if the above situation keeps on lingering for longer periods. If this happens, the business will go bust. Thus, we can say, that even if the business is profitable, but due to improper cash flow management, it went bust.