It’s easy to confuse certain accounting terms. Cash flow and profit and are particularly easy to mix up.
This article explains the difference and importance of the two.
What is cash flow?
Fundamentally, your cash flow is the net amount of cash that’s being moved into and out of your business over a certain period of time.
A healthy cash flow is necessary for keeping your daily operations going, paying taxes, purchasing inventory, paying employees and seeing to other operating costs.
Positive cash flow indicates that a company’s liquid assets are getting larger. Those liquid assets, i.e. cash, enable a company to settle its debts, reinvest in its business and provide a buffer against any future financial challenges.
By contrast, a negative cash flow indicates that a company’s liquid assets are decreasing.
As a business owner, you want to keep your cash flow positive. In part, having cash available (i.e. liquidity) allows you to pay for things like debts and other expenses. On the other hand, positive, growing cash flows are one sign of a healthy business. They help demonstrate that a company’s business model is working.
What is profit?
Unlike cash flow, which is simply the net amount of cash moving into or out of your business, profit is the money that remains after all expenses are accounted for. Profit is the overall picture of a business and is the basis on which tax is calculated. This is why profit is sometimes referred to as ‘the bottom line’.
There are three major types of profit that analysts analyze: gross profit, operating profit, and net profit. Each type of profit gives more information about the company’s performance, especially when compared against other time periods and industry competitors. All three levels of profitability can be found on the income statement.
Gross profit: A company’s gross profit is the profit it makes after deducting all the costs that are directly associated with producing its products or services. Gross profit can be calculated by subtracting a business’s revenue from its “cost of goods sold”. “Cost of goods sold” refers to all expenses that can be directly attributed to the production of goods sold by a company.
Operating profit: Operating profit is measured by looking only at core business functions, and excludes deductions such as interest and taxes.
Net profit: This the actual profit, after all expenses of every type have been deducted.
By developing a clear understanding of the three types of profit, business owners can develop a clear overall picture of the health of their company.
Cash, profit and business growth
Over the long term, profit is the true mark of any business’s health. Yet adequate cash flow also remains crucial. Which is why you should keep an eye on both the long-term and short-term needs of your business when managing your accounts.
Consider the following:
Payment synchronization issues: If a company gets caught between suppliers who have short payment terms and buyers who are slow to pay, a successful product with increasing sales can create a crisis in cash flow. Why? Even though the company’s sales are increasing and profitable, the company doesn’t get paid in time to pay its suppliers, or meet payroll and other operational expenses.
Excessive corporate spending: the success of a product may lead a company to make overly-optimistic spending decisions, such as buying expensive equipment and making unnecessary improvements to facilities. These can leave a business low on cash, though the company remains profitable.
In short, the key difference between cash flow and profit is time. Profit can’t show you the whole picture of how your business is doing in the short term because profit doesn’t tell you when inflows and outflows of cash are coming.
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