Profit without cash: how a company can go bust while making money

A company can report profits and yet run out of money to pay its debt, its wages or its suppliers. The key lies in the difference between accounting profit and cash flow: one thing is what you say you earn, another is the money that actually comes in and goes out. In a heavily indebted company that difference is not a technicality: it is the origin of most insolvencies caused by illiquidity.

The difference between profit and cash flow#

The income statement carries two white lies for an indebted company. The first: it includes expenses that are not an outflow of money —depreciation, write-downs— that move profit without touching the current account. The second, more dangerous: it does not record the repayment of the debt principal. Paying a 30 million maturity does not subtract a single euro from profit, but it empties the cash exactly like paying wages.

Add working capital to it. To sustain sales you have to finance customers and hold inventory; that money is out there, not in the bank. A growing, indebted company can earn more on paper every quarter while its treasury tightens month by month. Profit rises; cash falls. Both things at once, and both true.

Why EBITDA is not cash#

EBITDA is sold as "the cash the business generates". It is not. It ignores interest, taxes, the investment needed to keep operating (capex) and working capital. A company can show a solid EBITDA and, after paying interest and maturities and financing its growth, end the year with less money than it started with. EBITDA measures the engine; cash measures what is left after paying for the fuel, the toll and the mechanic.

The scissor effect: when EBITDA falls and debt does not#

A company's revenues are cyclical; its debt payments are not. Interest and maturities are fixed in a contract and it makes no difference whether the year turns out good or bad. When EBITDA contracts —a recession, a customer that leaves, a margin that tightens— the debt service stays where it was. The two lines cross, and what falls below is free cash flow.

Here is the nuance that avoids alarmism and is not told enough: in low-rate cycles, many companies with this picture survive without trouble by refinancing over and over. The blow comes when credit gets more expensive or shuts down just as EBITDA falls. It is not debt that kills; it is the debt that has to be rolled over at the worst moment.

How to spot an over-indebted company#

The shareholder looks at earnings per share. Whoever lends the money looks at something else, and looks at it first. There is no magic number —thresholds vary a lot by sector—, but these are the three signals reviewed before the net result.

The same profit misleads in different ways depending on the sector. It is worth knowing where to look in each case:

What happens when a company runs out of liquidity#

It does not go bust from losing money: it goes bust from not having it when it has to pay. A negative free cash flow forces it to draw on more debt or on the existing cash to plug the hole, which raises future debt service and tightens the next financial year. It is a spiral, and it is called exactly that in the rating agencies' reports. Profit may keep being positive throughout the whole process. That is why it misleads.

How to apply it without going mad#

You do not need a 40-tab model. By looking at three things in the annual accounts —interest coverage, net debt to EBITDA and whether free cash flow is positive on a sustained basis— you already separate most of the wheat from the chaff. If all three are fine, the headline profit is probably real. If all three are bad, the profit is a facade. It is the same approach we apply in the rest of Finoview's ratio analysis.