Butterflies and moths, crocodiles and alligators, speed and velocity. There are lots of things that seem like they’re the same but are actually quite different. In the business world, the topic of cash flow vs profit continues to confound.
As advocates of better cash flow knowledge and long-term financial health, we present this overview of the Batman and Robin of the finance universe — cash flow vs profit. A dynamic duo all their own, cash flow and profit are often part of the same discussion, but each has its own specific meaning and role.
The “textbook” definition of cash flow
Cash flow is the pattern and amounts of cash that move in and out of business over a set period of time.
- Cash flowing into a company is called an inflow, while cash flowing out is an outflow.
- It is primarily a measure of liquidity or a company’s ability to meet its short-term obligations, such as fulfilling orders, meeting payroll and other routine operational costs.
- It is measured across operations, investment and financing activities — with the operational or day-to-day incomes and expenses, especially accounts receivable and accounts payable, taking center stage.
Cash flow = operational cash flow + investment cash flow + financing cash flow
The primary metrics for cash flow are recorded in a cash flow statement.
The “textbook” definition of profit
Profit is literally revenue minus expenses. It’s the total amount of money that a company brings in, minus the total expenses.
It’s a measure that simply determines if the company is bringing in enough sales to cover the overall cost of running the business and generate a surplus.
The variables for profit are recorded in a profit & loss statement, also known as an income statement.
Profitability is a factor of gross profit and net profit.
Gross profit = revenue – cost of goods sold (COGS)
Net profit = gross profit – operating expenses
As an example, here are the numbers for Joe’s Trucking:
Joe’s Trucking earned $30,000 in revenue one month, but its COGS was $10,000. On top of that, there was another $5,000 in operating expenses.
Gross profit = $30,000 (revenue) – $10,000 (COGS) = $20,000
Net profit = $20,000 (gross profit) – $5,000 (operating expenses) = $15,000
Cash flow vs profit — the different math
One difference between cash flow and profit is that cash flow only records income when it comes in, such as when an invoice is paid. Profit is recorded as it hits the books when an invoice is sent out, instead of when it’s paid.
For instance, if the $15,000 net income for Joe’s Trucking is only accounting for outflows stemming from COGS and operating costs. However, it doesn’t reflect the impact of unpaid invoices.
So, if Joe’s Trucking recorded $20,000 in invoices issued, but none of the invoices were paid, they’d actually have a negative cash flow of $5,000.
$15,000 (net profit) – $20,000 (accounts receivable outstanding) = -$5,000
This means that while Joe’s Trucking is profitable, it’s cash flow wasn’t as healthy.
Cash flow vs profit — there’s no direct relationship
Cash flow tells you when money is going out and when it’s coming into your company, while profit doesn’t reflect the timing of inflows and outflows.
As a result, while cash flow and profit are related, they’re not directly correlated. If one is positive, the other won’t necessarily be positive and vice versa.
It’s also a reason why businesses can get frustrated come tax time as business income taxes are calculated based on profit rather than cash flow. If it looks like you’ve made money, you’ll have more taxes to pay, even if you don’t have the money to do so.
Cash flow vs profit — the four scenarios
1. How a business can be cash flow positive and profitable
This is the best-case scenario that every business targets — positive income growth coupled with positive cash flow. It means the business has healthy sales and that its cash flow cycle is balanced so that there’s always enough to meet regular expenses as they’re incurred.
2. How a business can be profitable and cash flow negative
A business in a rapid growth phase might be highly profitable but have a shortage of cash due to the investment needed to meet demand, such as an equipment purchase. Or, it could be that their accounts receivable cycle is out of sync with their accounts payable. Money’s coming in, just not at the right time. This is why accounts receivable gets so much scrutiny as part of a cash flow analysis.
Fact: Small to medium-sized businesses are more likely to be “cash poor” because they use their operational cash flow as the main source of business funding. They simply don’t have the reserves of a Fortune 500 company.
3. How a business can be cash flow positive with no profit
This scenario is most likely for new or early-stage businesses and startups. For example, if a startup has a cash influx due to investor funding while the product or service is under development. Or, it could be a business that just opened its doors. It has the reserves to get to a starting point but hasn’t begun to record income.
Another reason a business can be cash flow positive without a profit is when the owner has secured financing to solve a lumpy cash flow. If the terms of the loan aren’t favorable, this can also lead to further cash flow struggles.
4. How a business can be cash flow negative and have no profit
Actually, you can’t be a business for very long without cash flow or profit. This is the worst-case scenario – no sales and no reserves. There’s likely a fundamental flaw in the business plan, the product, pricing or all of the above. Hint: Nobody aims for this one.
Cash flow is a stronger indicator of success than profit
There’s a reason why Batman is always the hero and Robin is a sidekick. Conspiracy theories aside, once start studying up on cash flow, it’s impossible not to stumble across the expression, “Cash is king.” Because, in the business world, it’s true.
Of course, profit helps, but the thing that matters most is having enough money at the end of the day to pay your bills. If you’re not paying attention, cash flow can be a silent killer. (Only no one’s developed a foolproof alarm like there is for carbon dioxide. A bat signal isn’t particularly effective either.)
Avoiding a cash flow crisis
Another reason that cash flow is so crucial to small and medium-sized businesses is that it’s harder for them to find short-term lending options. Even credit cards are hard to come by if you’re business is new or your credit rating has taken a hit. And traditional loans and lines of credit have lengthy application processes.
It’s also why online lending and financial tools been developed to meet these needs. Tools like cash flow forecasting that connects to your online accounting software and financing options like invoice factoring to help you get affordable funds more quickly.
This article is informational only. It does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
Image via Shutterstock.