This article explains cash flow and profit, as well as the key differences between them – dry, yet important!
Many businesses are started with a grand idea of a product or service, and many business owners aim to create a profit from that grand idea, skipping over any thoughts of cash flow. What many entrepreneurs and business owners don’t realize or consider, is that cash flow is essential for day-to-day business… which is quite important if you are wanting to keep the lights on! Cash flow and profit are two finance terms used in the business world often, however, have you ever stopped to consider if you truly understand what they are and the differences between them? Profit is more indicative of the business’s overall success, while cash flow is what keeps the day-to-day operations running and the heat on; each a very important aspect of a company’s financials! Let’s explore further what cash flow and profit is, along with the key differences.
While profit is the goal for business owners, cash flow is an important metric that helps determine the short-term and long-term outlook of the business. Cash flow is the net amount of cash moving through the company at any given time. It’s important to understand that a business’s cash flow only includes the cash transactions of the business, meaning non-cash items such as accounts receivable, and depreciation of assets such as equipment would not be included in the cash flow statement – it is solely cash you received in your bank account, and cash that was spent from your bank account. Highly successful business owners know the exact amount of cash they must have accessible in their bank account at all times to be able to cover the operating costs of their business in order to stay in business and keep the doors open.
Cash flow is best understood in a given time frame and most successful businesses track their cash flow month-to-month through financial reporting, which is called the cash flow statement. The net cash flow is calculated by taking the cash received for the month, minus the cash spent for the month. A positive cash flow is when you have more money coming into the business than going out, while a negative cash flow is the opposite with a greater amount of money going out than coming in. The cash coming into the business is cash inflow, while the cash leaving the business is cash outflow.
Cash Flow can be broken-down further into 3 sections:
1. Operating Cash Flow: Net cash from a company’s normal business operations. For companies that are actively growing and expanding, a positive cash flow becomes essential to accomplish growth.
2. Investing Cash Flow: Net cash from a company’s investment-related activities, such as purchasing physical assets like equipment, property, and investments such as securities. Companies with healthy financials that are actively investing in their business will usually have a negative balance for this section.
3. Financing Cash Flow: Net cash moving between the company and its investors, owners, or creditors. This is the net cash to finance the company, which may include debt, equity, and dividend payments.
Profit is the most common metric looked at to determine a business’s success. Profit is defined as the balance that remains from your income after paying all operating costs to generate that income. Another way to look at this is what money you have left from your revenue after all the expenses have been subtracted from that income.
Profits can be reinvested into the company, for example, by purchasing more inventory for sale, investing in research & development, or purchasing equipment. Profits can also be distributed to the shareholders, often in the form of dividend payments. Like cash flow, profit can be shown as a positive or a negative.
When Profit is a negative number, it is most often referred to as loss, as the company spent more money operating than it could generate money from income and therefore “lost” money. A company’s profit is most often shown in financial reporting through the income statement, also known as the profit and loss statement (P&L). The income statement shows the business’s revenue, gains, expenses, and losses over a specified period of time.
Profit can be broken-down further into 3 sections:
1. Gross Profit: Defined as the revenue less the cost of goods sold. This includes variable costs that change depending on the level of output, such as cost of materials or labour directly associated with production of goods sold. This does NOT include fixed costs that company must pay regardless of output, such as rent, or salary of individuals not involved in the production of goods sold.
2. Operating Profit: Net profit a company generates from its normal business operations. This typically excludes cash outflows such as tax payments or interest on debt payments. It also excludes cash inflows from areas outside of business operations. This is sometimes referred to as earnings before interest and tax (EBIT).
3. Net Profit: Net incomes once all expenses have been deducted from all revenues. This would include expenses such as interest and taxes, as well as all revenue sources for the business.
With Cash Flow and Profit now clearly defined, let’s take it a step further and list out some of the key differences between the two:
- Cash Flow is the net flow of cash in and out of the business
- Profit is the balance of money left in the company after all expenses are paid
- Cash Flow is ONLY cash transactions in the business
- Profit includes all transaction types in the business
- Cash flow is necessary for operating expenses to keep the company running – if you have negative cash flow yet positive profit you are still in trouble! Cash is necessary to pay the bills.
- Profit doesn’t tell you when you are getting inflows and outflows of cash
- Cash Flow gives a good picture of time, and when inflows/outflows occur
- Cash Flow can give a day-to-day understanding of a business’s financial well being
- Profit can show the overall success of a company – not if they have the money to endure long-term
- It’s possible for a business to be profitable yet have negative cash flow, most commonly from mismanagement of finances
- A company can’t maintain positive cash flow long-term without a profit
Profit for the month = Revenue ($10,000 total sales) – Expenses ($5,000) = +$5,000 (profit)
Cash Flow for the month = Cash Inflow ($4,000 cash sales) – Cash Outflow ($5,000 paid out) = -$1,000 (negative cash flow)
Are you positive?
Yay – wasn’t that exciting information? Honestly, while this content is somewhat dry or boring, this is very important information for business owners and executives to understand. Keeping a company’s profits and cash flow positive are essential for growth and expansion, and more importantly to keep the doors open and remain in business. Many business owners are focused on the profits of the company and cash flow can be forgotten, which becomes an issue when it is in the negative and hinders many business operations, including the opportunity to grow and create more profits. Now that you have a greater understanding of cash flow, profits, and the key differences, it is time to ask yourself the important question: “Are my profits and cash flow positive?”