Cash flow and profit are both essential for a healthy and sustainable business. Many business owners might think cash flow and profit are interchangeable. However, they are not the same thing and it’s important to know the difference between the two.
As a small business owner, understanding the difference between making money and managing money will be critical to achieving long-term success. While the goal of most of the businesses is to run a profitable operation (increasing revenue and limiting expenses), but what they don’t realize is that cash flow is what keeps the lights on and doors open.
Businesses can be profitable and still have inadequate cash flow in their bank account, and others can have a lot of cash flow and no profit to show for it. How can a business make a profit but still cash flow negative?
In this blog post, we are going to break down the key differences between cash flow and profit that will help you make better financial decisions, understand your cash position, and meet your short and long-term business goals.
Profit, also known as net income, is the revenue remaining after all costs (labor, materials, interest on debt, and taxes) are paid. In other words, it is the difference between revenues and expenses.
For example, if a food trucks’ revenue on a given day (customers’ food bills) equals $2,000 and its daily expenses (food costs, phone/internet, labor, fuel) equals $850, the profit for that day is equal to $2000-$850 = $1150
Whether it is a small retail store or a multi-national company, the main goal of any business is to earn money, therefore profit is the ultimate indicator of success. It is obvious that a business cannot long survive without generating a good profit.
However, all types of profit reflect your businesses’ profitability differently. There are mainly 3 types of profit: Gross Profit, Operating Profit, and Net Profit. Let’s learn a bit about them:
Gross profit is the revenue of business after deducting the cost associated with making and selling its products or providing its services. It is calculated by subtracting the cost of goods sold (COGS) from revenue.
Gross Profit equals Revenue minus Cost of Goods Sold
Gross Profit estimates a company’s efficiency at using labor and supplies in producing goods and services. It considers variable costs that change in proportion to production output, such as:
- Purchase price of goods
- Materials and equipment used to manufacture a product
- Direct labor
- Shipping etc.
Operating Profit, also called EBITA (Earnings Before interest & taxes, Depreciation, and Amortization), is the profitability of a business from its core business functions. In simple words, it’s the difference between operating expenses and gross profit.
It can be calculated using the below formula:
Operating Profit = Revenues – Cost of Goods Sold – Operating Expenses – Depreciation and Amortization
Operating profit tells how well a company is being managed and presents its financial situation positively in a high debt load case.
Net profit is a more accurate reflection of a business’s profitability than any other type of profit. It is the amount of money a business earns after subtracting the total business expenses form total revenue.
Net Profit – Gross Profit – Expenses
Net Profit is really important because it demonstrates the real health and success of a business. It also gives you an indication of the money you have available to pay to the owners and/or invest back into the business.
What is Cash Flow?
Cash flow is the money moving in and out of a business at any given time. In finance, it is the net amount of cash that is generated in a given time.
The money that is coming in from selling products or services (Income) and the amount owned resulting in providing goods on credit (account receivable) to customers/vendors are included in cash-inflow. Whereas, the money that is going out in the form of payments and wages (Expenses) and the amount owed to a supplier for goods and services (Accounts Payable) are included in cash-outflow.
Cash flow positive is when cash moving into the business is more than cash moving out of the business at any given time. Naturally, positive cash flow is preferred. It means you have enough cash to cover regular operational costs and expenses. High positive cash flow allows you to determine problems with business’ liquidity, increase liquid assets, evaluate the quality of business income, make new investments and further grow your business.
Cash Flow Can Be More Relevant Than Profit
Imagine this hypothetical: You’re looking to purchase a new office and hiring new employees next month. Your accountant looks at your company’s balance sheet and reports that your business turned a sizable profit this month so you can make these investments. While this is great news, your excitement is not going to last long. Why? Because there is not an adequate amount of cash in your bank and you have no idea how you’re going to bear these enormous expenses.
A profitable business can have insufficient cash flow. The truth is that profit can make your company look big on paper, but you can’t pay rent, meet payroll and pay out your bills without sufficient cash. Without healthy cash flow, your business won’t survive. Your business may have great sales, a book full of orders, thousands of satisfied customers and clients, and amazing business credibility, but without the ability to generate cash, it’s destined to fail.
Below are the top reasons why it is more important to monitoring and strengthening cash flow than focusing on your bottom line.
- The more cash you have means the more liquid your business is. Having enough cash at your disposal to effectively and timely cover all your bills and liabilities in the forthcoming period is essential. A lack of liquidity can damage your credit rating and have negative impacts on your business too.
- Maintaining a positive cash flow means you’ll have more opportunities to grow. You can purchase inventory, equipment, raw materials and make other investments as and when you need it.
- If you have a healthy cash flow, it means you are ready for any increase in expense due to an increase in demand such as advertising, staff wages, office space, and inventory costs.
- A strong cash flow allows you to make better financial decisions and helps you prepare for critical uncertainties that may affect your business in the future – when sales are down or face problems in repaying a loan.
- Making important investments, promoting your business, and meeting your business’ short and long-term objectives and goals cost a lot of money. If you are able to maintain a positive cash flow in your business, you will be better positioned to secure financing, attract investors and take your business to the next level.
Maintaining the Cash Flow
No matter how profitable your business is, if you fail to generate cash to pay your bills and invest in the business in the short term, you can’t survive and thrive in the long-run too.
Using a futuristic cash flow forecasting software like PayPie for your business can help you predict and control cash flow more accurately.
With PayPie, you can track your business’ cash flow in real-time, simulate different scenarios, review your finance in a glimpse, and analyze your financial data – giving you a clear picture of your past, present and future cash position and allowing you plan accordingly.
Signing up for PayPie is easy! Simply create your free account, connect your business and run your cash flow forecasts.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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