Warning: Profits are not the same as cash flows

Last year, Chris’s Chrysler dealership reported its highest pretax earnings in five years. But when it came time to pay taxes, there wasn’t enough cash in the dealership’s checking account. Sound familiar? Many dealer-owners mistakenly equate profits with cash flow. The truth is that there are many reasons these numbers might differ.

Working capital fluctuates

Profits (or pretax earnings) are closely related to taxable income. Reported at the bottom of your dealership’s income statement, they’re essentially the result of sales earned less the cost of inventory sold and the expenses incurred in the accounting period.

Generally Accepted Accounting Principles (GAAP) require companies to “match” costs and expenses to the period in which sales are earned. It doesn’t necessarily matter when you pay for a product or service.

So, the used car and floor mats that haven’t sold for 18 months can’t be deducted — even though they’ve been long paid for (or financed). The cost/expense hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.

Other working capital accounts — such as warranty receivables, accrued expenses and trade payables — also represent a difference between the timing of cash outflows and the matching of expenses to sales. As dealerships grow and prepare for increasing future sales, they need to invest more in working capital, which temporarily depletes cash.

Profits exclude capital expenditures and debt

Working capital tells only part of the story. Your income statement also includes depreciation and amortization, which are noncash expenses. And it excludes capital expenditures and bank financing, which both affect your cash on hand.

To illustrate: Suppose Chris’s Chrysler dealership purchased two new lifts in December 2012 to take advantage of the expanded Section 179 depreciation allowances. Under Sec. 179, Chris was able to immediately deduct the purchase price of these items, which lowered his taxable income in 2012. Both purchases were financed with debt, so actual cash outflows from the investments were minimal in 2012.

In 2013, Chris made loan payments, and the principal repayment portion of these payments reduced the checking account balance but not profits. In addition, there was no basis left in the 2012 purchases to depreciate in 2013. Like many small dealers, Chris used the same depreciation schedules for book and tax purposes. These circumstances made the Chrysler dealership appear more profitable in 2013 than in 2012, but there may not have been an increase in cash.

Owners can deplete or replenish cash

You also can link discrepancies between profits and cash flows to owners’ equity accounts.

For example, Chris paid himself a generous dividend last December to celebrate a strong uptick in sales. The payout lowered the dealership’s checking account balance. But shareholder distributions — similar to capital expenditures and principal payments — aren’t subtracted when computing profits (or taxable income). Ultimately, Chris may need to use a portion of these distributions to fund the 2013 tax bill.

It’s a fact of life

Differences between profits and cash flows will always take place. Some growing, profitable dealerships will experience cash shortages. And some mature “cash cows” will have ample cash on hand, despite lackluster sales.

It may seem counterintuitive that profits don’t equate with cash flows. But as long as dealer-owners understand the sources of these discrepancies, they’re less likely to be blindsided when the tax bill comes due or they want to fund an investment opportunity.