Cash Flow vs. Profit: Understanding the Difference
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It’s simple to assume that if a business is profitable, it has ample cash flow. Why wouldn’t a business that brings in X amount per year be able to pay a few bills?
Well, if a billing cycle takes months at a time for invoices to be paid, then cash would be tied up in these invoices. Only when the client paid—if the client paid—would the money be available. So a company paying its bills could be contingent on when its clients pay them.
What happens if a business is still waiting to be paid while still having bills to pay?
Worst case scenario, poor cash flow can prevent a business from paying its bills, causing it to go out of business despite being profitable.
“The key is how you cover your ongoing expenses while you’re waiting from them to pay,” said Terri Denison, district director of the Small Business Administration Georgia District Office.
As this example notes, making money and having access to these funds at any given time to use for the day-to-day running of a business are two different things.
Here lies the root difference between profit and cash flow. Continue reading to learn more about how each can impact a business, and why you want to have both a positive cash flow and profitable business to thrive.
What is cash flow?
Cash flow refers to the incoming and outgoing of cash. Cash flow is measured and recorded on a cash flow statement, which shows the difference in cash flow from month-to-month.
Cash flow is about timing of cash coming into your business from sales that you make, and the outflow of cash because you have to pay for materials or other things related to providing a good or service,” said Denison.
Over the course of the life of a business, an owner will have to make deposits and withdrawals. This inflow and outflow of money includes items such as paying for rent or supplies, and accepting payments from customer invoices.
You will have overhead costs that you will have to pay no matter what you sell or how much you sell. So the key is the timing where you have cash coming in and cash going out, how much cash you need to have available should unexpected costs come about, said Denison.
Cash payments allows for an immediate infusion of cash back into the business, while payment via credit and debit card will have a delay before the amount is received.
If someone purchases a product or service from you by invoice and you extend 30 days to repay after you’ve provided that service, you still have an expense in the meantime. You may need a line of credit or have some type of reserve to fill in the gaps,” said Denison.
There are two types of cash flow—negative and positive.
Negative cash flow occurs when cash outflows outweigh cash inflows. More money is going out than a business is bringing in. Positive cash flow occurs in the opposite scenario. A business brings in more money than goes out. Positive cash flow is the goal.
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What is profit?
Profit is revenue minus expenses.
An income statement will highlight the business’s financial performance over a certain period of time, and presents sales and expense information over a certain time period. An income statement shows net income, or profit.
Tips for improving profit
Here are three tips for increasing profitability:
1. Identify possible businesses you can enter into strategic partnerships with to increase revenue. “A lot of times, the whole point is to try to maximize your revenue as much as possible, and of course that would be by looking at who’s your target market. Can you expand?” said Denison.
2. Look for ways to innovate a product or service to find new customers.
3. Identify the cost per unit for a product or service to determine whether it is profitable or not. Eliminate if needed.
Cash flow vs. profit: How do they differ?
A business will have varying scenarios where issues with either profitability or cash flow can occur. Let’s take a look at a few examples.
An owner has put $25,000 of his own money into starting a new restaurant. He has been able to buy equipment, hire a new staff member and cover expenses through this infusion of equity. He has no profit yet, but because of the inflow of available cash and his ability to use it on-hand to cover expenses, this business has positive cash flow. However, his new restaurant has not made money yet, so he has no profit.
A business owner has her eyes set on a new car and decides to use business funds to purchase it. Their business is also profitable and has been for the last decade. However, the all-at-once car purchase used the total amount from the last few invoice payments—the three largest of the pay period. Unless this owner has access to another source of working capital, her business will soon have cash flow issues because of the car purchase that used a large amount of the cash on-hand.
A business sells widgets wholesale and turns a hefty profit. However, customers can take up to 120 days to pay. This situation has the potential to leave a business unable to pay its bills on time (if any are due before 120 days, and which some will likely be). This business suffers from profitability with a negative cash flow.
Which is more important to a business: cash flow or profit?
Both profit and cash flow are integral to business survival. In many cases, a business will need to be profitable before having cash flow. Profit is important for this reason.
Ultimately, however, cash flow is more important because once a business is profitable—which is the goal of having a business—it needs to be able to run. Cash flow allows a business to maintain operations.
“There’s an old expression. Cash is king—or cash is queen for me,” said Denison.
“In the long term, the business has to earn a profit. Otherwise you wouldn’t be entering into business to begin with. In the short term as well as in the long term, you have to be able to have very little difference between the cash going in and the cash going out,” she said.
“Between the two, cash flow is more important. Especially in the short term, in order to get anything done, you need cash flow.”
Common terms to know:
Below are important terms to know when reviewing your business’s cash flow and profit.
- Cash flow: the way money goes in and out of a business to allow it to function on a day-to-day basis
- Cash poor: a lack of available cash at any given time in a business; caused by cash flow problems
- Profit: revenue minus expenses
- Liquid assets: assets that are cash-convertible
- Revenue: income from goods sold
Understanding the difference between cash flow and profitability is essential to understanding the ins and outs of a business. Both are necessary for a business to thrive. To keep business funds organized and accessible, separate business from personal expenses. Have a system that tracks cash inflow and outflow. And work with a trusted bookkeeper or accountant. Give your business the tools it needs to thrive as a profitable entity with a healthy cash flow.