As a Small Business Owner, understanding the difference between cash flow and profit is crucial for making informed financial decisions. While both are essential metrics for assessing a company’s financial health, they serve distinct purposes and can impact business operations differently.
Cash flow refers to the net flow of cash in and out of a business, while profit indicates the amount of money that’s left over after all of the expenses have been paid.
A business can be very profitable while having poor cash flow. The opposite is also true — a robust cash flow doesn’t necessarily mean a business is actually profitable. Investors and business owners alike use these important metrics for things like deciding when to invest or what business strategies should be used.
It’s especially important for businesses to consider and calculate the demands of cash flow vs. profit accurately. Accurate bookkeeping is essential for both forecasting cash flow and calculating business profits, regardless of the size of your business.
Why Is Understanding Cash Flow vs. Profit Important?
Before we delve into the details, let’s grasp the importance of these two financial metrics:
- Financial Decision-Making: Accurate knowledge of cash flow and profit helps accountants and business owners make
informed decisions. Whether you’re budgeting, planning investments, or managing day-to-day expenses, having a clear understanding of these metrics is essential.
- Sustainability: Cash flow and profit impact the sustainability of your business. A company might be profitable but could still face financial hardships if it experiences cash flow problems.
- Investor and Lender Relations: If you’re seeking external investments or loans, potential investors or lenders will scrutinize your cash flow and profit statements. Clear and transparent financial data can attract investors and help secure financing.
- Growth Opportunities: Understanding the difference between cash flow and profit can open up new growth opportunities for your business, helping you navigate expansion more effectively.
The Difference Between Cash Flow and Profit
In order to run your business smoothly, it’s important to grasp the different between your business’s cash flow vs. profit. As a business owner, you need to not only understand the differences between the two terms, but also to be able to leverage both to your advantage.
Cash Flow
Cash flow consists of all money that comes in and out of your business over time. Positive cash flow happens when there is more money coming in than going out, while negative cash flow means that there is more money going out than coming in.
However, there are certain things not included in business cash flow, which include:
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- Money owed to creditors.
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- Money in the bank
- Credit from suppliers
Business cash flow is used as a metric to determine the health of your business. Lenders and investors may use it to assess how well your business is doing.
Profit
Put simply, business profit is revenue minus expenses; it is also referred to as “net income.”
When it comes to calculating business profits, there are two types of profits:
Gross Profit
Gross profit is the profit of your business after deducting the costs it takes to provide goods and/or services.
Net Profit
Net profit is the profit after everything — including taxes and operating expenses (such as payroll, rent, utilities) — have been deducted.
Cash Flow vs. Profit:
Which is More Helpful to Understanding Your Company’s True Health?
When it comes to business cash flow vs. profit, which is more helpful for understanding the health of your company?
Many business owners & investors — want to know the one metric that will determine the health of the business so they can decide the direction to take with their business strategies.
Business profit illustrates the immediate and short-term success of your business. Alternatively, cash flow can be used to more accurately determine the long-term financial outlook of your company.
To be successful in the long run, a business needs to maintain both positive cash flow and profit. The critical difference between business cash flow vs. profit is time.
Understanding how these two interact can help you to make better business decisions.
Understanding Cash Flow
Cash Flow is like the Lifeblood of Your Business
Cash flow refers to the movement of money in and out of your business, indicating how well you manage your liquidity. There are three main types of cash flow:
1. Operating Cash Flow: This represents the cash generated from your day-to-day operations. It includes revenue from sales, payment from customers, and operating expenses like rent, utilities, and payroll.
Investing Cash Flow: This pertains to the cash used for investing inassets like equipment, property, or securities. It also includes thecashreceivedfrom selling suchassets.
2. Financing Cash Flow: This accounts for cash activities related to the business’s financing, such as loans, repayments, and equity investments.
Real-World Example: Cash Flow
Let’s say you own a small retail store. In January, you sell $50,000 worth of merchandise, but you allow customers to pay in 30 days. Your expenses for the month, including rent, utilities, and salaries, amount to $30,000. While your profit for January is $20,000 ($50,000 – $30,000), your operating cash flow for January is $0, as you haven’t received any money yet.
This example illustrates how profit doesn’t always equal cash flow.
Profit: The Bottom Line
Profit, on the other hand, is the excess of revenue over expenses during a specific period. It’s an important indicator of the overall health of a business but doesn’t always reflect its liquidity. There are two main types of profit:
1. Gross Profit: This is the profit after subtracting the cost of goods sold (COGS) from the revenue. It shows how efficiently a company produces and sells its products or services.
2. Net Profit: After deducting all operating expenses, taxes, interest, and other costs, you get the net profit. This is the final profit figure that indicates how much money you’ve made after all expenses.
Real-World Example: Profit
Imagine you own a software development company. In a year, your total revenue is
$500,000, and your total expenses, including salaries, office rent, and software licenses, add up to $400,000. Your gross profit is $100,000, and after subtracting taxes and interest, your net profit is $50,000.
It’s important to note that while your profit looks healthy, your cash flow may fluctuate due to delayed client payments, leading to potential cash flow issues.
The Key Differences
Now that we’ve explored cash flow and profit individually let’s summarize the key differences:
- Timing: Cash flow focuses on the timing of money moving in and out of your business, while profit considers financial performance over a specific period (e.g., a month, quarter, or year).
- Inclusions: Cash flow accounts for all cash transactions, including expenses and investments, whereas profit primarily addresses revenue and expenses related to the core business operations.
- Liquidity vs. Long-Term Performance: Cash flow measures short-term liquidity, ensuring you can meet immediate financial obligations. Profit, on the other hand, reflects the long-term financial health and profitability of the business.
Of course, every business wants to increase sales; however, if cash flows do not increase at the same rate as your sales, you can find your business running short on cash.
For example, for a business, selling more products often means spending more cash (an outflow of cash) to buy the products to stock the shelves or inventory; however, the cash inflow from sales may not be immediately available for use.
Business growth is important for profit. Although it seems contradictory, growing your business can result in cash flow shortages. For example, when growth is high, a business may accept more orders but not have enough cash to produce and deliver them.
Cash flow is the lifeblood of any business, so it is important to manage your cash flow carefully. There are several options available for managing small business cash flow, which we’ll explore in depth below.
Cash Collections on Previous Sales
For various reasons, you may not immediately receive the cash from your sales upfront. Similar to delaying payments to a supplier, there may be a delay in receiving cash from the products you sell and deliver.
For example, cash from June sales may not be available until July. The risk of this is that you could be short of cash in June and not have enough to meet all of your outflow needs for that month, even though June was a busy month.
Delay Cash Payments
Delaying cash payments to suppliers reduces the immediate need for cash. For example, when you’re purchasing products, you may negotiate with the supplier to pay a certain percentage upfront and then pay the remaining balance within a certain amount of time, say a month or six weeks.
The advantage to this kind of arrangement is that you don’t have to put up all the cash upfront to get the product, but you are in effect borrowing against your future business because you will have to pay out when the delayed payment comes due.
Raise Capital / Funding
If you do not have sufficient amounts of short-term cash, raising capital may be an option. One way to raise capital is to borrow money. If your business is big enough, you can issue stock, which means that an investor gives you cash in exchange for purchasing a piece of ownership of your company.
If you are under pressure, you may feel compelled to accept a loan with a higher interest rate than you’d like or sell more ownership than you would prefer.
Both these ways of raising capital have downsides, which makes raising capital the least attractive cash flow management option. Borrowing money means that you will have to pay it back in the future, often along with interest.
Issuing stock means selling a part of your business. Depending on the percentage and terms, it may mean that someone else may be entitled to have a say in the way that your business is run.
Understanding Profit
Increasing business profits can be beneficial for your company; however, it is always important to remember that any new source of profit (such as developing a new product or adding a new service) may also raise your expenses.
Because this could push your costs beyond what is feasible (and result in an overall loss of profit), calculating business profit on new ventures is very important. Small business profits may be especially vulnerable to upfront costs for new lines of products or services.
Strategic Planning
Small business cash flow considerations are particularly important because newer businesses may have less cash flow to draw on.
Regardless of the size of your business, good planning involves careful and accurate bookkeeping. This is essential for both legal and financial purposes. Moreover, it can help you manage cash flow vs. profitability.
With the advent of the Internet, online bookkeeping has become an advantageous way to track your business accounts. Accurate, up-to-date records will give you a snapshot of the health of your business, as well as your cash flow.
Timely bookkeeping can also help you avoid the need for catch-up bookkeeping. However, if you do need to catch up, Prolific Financial is here to help.
Putting It All Together
Though higher business profits is an important goal for any business, you must plan carefully to balance cash flow vs. profit. As noted in this article, it is possible for a business to be profitable, but still have poor cash flow.
Conversely, a business can have robust cash flow but have little profitability. To properly manage both business cash flow and profits, you need accurate, timely bookkeeping to allow you to make better financial decisions and secure long-term success.