Cash Flow vs. Profit: Understanding the Difference
When you’re running a business, keeping track of all of the financial terms can be enough to give you a headache! But two of the most important terms that will affect you are your cash flow and your profit.
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 mean a business is necessarily 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.
The Difference Between Cash Flow and Profit
To manage your business effectively, it’s a good idea to have a firm grasp on business 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 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:
- Money owed to creditors
- 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.
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 is the profit of your business after deducting the costs it takes to provide goods and/or services.
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 for Understanding Your Company’s Health?
When it comes to business cash flow vs. profit, which is more helpful for understanding the health of your company?
Many business owners — along with 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. Unfortunately, there isn’t a simple answer to the business cash flow vs. profit question because both cash flow and profit are important to the health of your business, albeit in different ways.
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
Obviously, every business desires to increase sales; however, if cash flows do not increase at the same rate as your sales, you can find your business actually 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. Though 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.
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.
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.
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.
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.
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, Xendoo can certainly help.
Putting It All Together
Though higher business profits are an understandable 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.