When you’re just starting out as a small business owner, it’s common to feel overwhelmed by the sheer amount of terminology and jargon. There are a couple terms in particular that confuse business owners: cash flow vs profit. Although the two may sound similar, they are quite distinct metrics. It’s essential that you’re clear about how they differ to fully understand the financial situation of your business.
What Is Cash Flow?
Cash flow is the amount of money that enters or exits your business during a particular period of time. It only refers to this flow of cash, not any other money your business has, such as savings in the bank or money clients owe you. Cash flow also does not take into account any money you owe. It is simply the amount you receive in payments and the amount you spend in expenses.
Put another way, cash flow is the amount of cash you have on hand in any given moment. Cash flow is dynamic — it can change at any time. For this reason, most businesses measure cash flow month to month.
To keep operating day to day, you need to have a positive cash flow. Otherwise, you’ll be unable to carry out regular operations, like buying inventory, making payroll, paying taxes, and covering all the other expenses your business has.
The best way to calculate cash flow is to use a cash flow statement. This is a template that allows you to input the money you had at the start of the month and then add or subtract all the inflows and outflows. It is important to only include what you paid and received within the month. For instance, if you made purchases with a credit card, include those costs in the month you paid the statement. For invoices you charged clients, use the month that the cash came into your business, rather than the date of purchase.
Once you have added everything up, compare the closing balance for the month to the opening balance. If the closing number is higher, you have a positive cash flow. If the number is lower, you have a negative cash flow.
What Is Profit?
Profit is the revenue you received from selling products or services. You may also see it referred to as net income. It is the amount that remains after you deduct the costs incurred to run your business. You have a profit if you’re receiving more money from sales than you’re spending to run your business. You can use profit to gauge the success of your business and it’s the number you’ll need to calculate tax.
It’s important to note that there’s more than one way of measuring profit. Two of the most used are gross profit and net profit. Each provides a different outlook to how your business is performing, such as during particular periods of the year or compared to competitors.
To find your gross profit, deduct just the costs related to producing and offering your products or services. You may also see this number referred to as the cost of goods sold (COGS).
To gain a more accurate picture of your profits, you need to look at net profit. This is a measure of your profit after subtracting COGS as well as taxes, interest on debt, and operating expenses (like payroll, rent or mortgage, and loan payments).
Cash Flow vs Profit: What’s the Difference?
There are significant differences between cash flow and profit. Many small business owners start out thinking that all they need to do is make a profit. This ignores the fact that cash flow is what allows you to operate.
Cash Flow vs Net Profit
Why is it possible to have a net profit but negative cash flow? It’s because it sometimes takes time before you receive cash after earning revenue. If you’re turning a profit but the money is unavailable (for example, the money is tied up in hard assets or accounts receivable), you may have a negative cash flow. You’ll need to wait for the debtor to pay you or receive more revenue to make your cash flow positive.
In fact, it’s not even uncommon to have a net profit but no cash. In this case, even though you’re turning a profit, you have no cash on hand to pay your expenses. This means you’re unable to meet near-term expenses and keep your business running. Furthermore, the net profit means you owe more income taxes, but you may have insufficient cash to pay tax.
The good news is that you can buy cash flow. As a business owner, you can use your personal assets for capital or you can apply for a loan. This will help provide you with cash in the moment you need it.
Positive Cash Flow vs Profit
Another source of confusion is the difference between positive cash flow vs profit. When a business has a positive cash flow, its liquid assets are increasing. (Liquid assets are anything you can turn into cash in a short time.) When you have a positive cash flow, you have the opportunity to carry out a number of additional activities, like paying down debts, reinvesting money, or returning wealth to shareholders, among other things.
A positive cash flow, though, doesn’t mean you’re profitable; it only means you have more money entering your business than you have leaving. If you have a large amount of debt, you may be able to keep your business operating without making a profit.
Such circumstances can arise if you are concerned that you’ll have a lack of cash to pay your suppliers or employees or meet another expense and you then borrow money to raise your cash flow. This extra debt may mean you are no longer making a net profit. If interest is too high, your cash flow will eventually decline until you reach a breakeven point.
Which Is More Important: Cash Flow vs Profit?
Is cash flow more important than profit? That depends on what information you want. Both cash flow and profit are good indicators of business success and show the chances of your company surviving through challenges. In this way, both matter — but they have quite separate purposes.
Cash flow gives you the information you need to keep your business running day to day. It is also a useful metric for banks and investors when determining if they should lend you money. However, profit is more important for telling you whether you’re reaching your goals.
Avoiding Problems with Cash Flow and Profit
Rapid growth can impact both cash flow and profit in a few ways. This is because developing a new product or service increases expenses. Understanding how and why this happens can help you prevent unexpected money problems.
For example, an influx of orders could lead to issues with cash flow if you lack the money needed to continue producing enough products. Plus, you need to bear in mind that investing in more resources to meet your targets could lower your profits.
Cash flow problems can also persist after sales due to higher customer service demands. You may have more customers seeking support or warranties. You could even have product recalls to take care of. If you are unable to meet these demands, your customers may be dissatisfied with the service they receive and decide to make future purchases with a competitor, which will impact your profit in the long run.
By keeping track of cash flow and profits, you can ensure that your cash flow stays positive. It may even be necessary to rein back growth to ensure you have sufficient cash flow now, even if this means sacrificing some profit. It is critical to figure out how you can lower your expenses by making appropriate cuts that will still allow you to stay in business.
Another thing you can do to prevent issues is forecast your cash flow. This involves tracking patterns with cash coming in and leaving. For instance, if you find that you are giving clients net 60 payment terms but your suppliers are giving you net 30 terms, you are always going to have problems with cash flow. Solutions could be to change the terms for your clients (or perhaps just new clients) or to use financing (such as line of credit) to ensure you pay expenses on time.
One of the major causes of failure in startups is thinking that cash flow is the same as profit. You’ve now seen that you can be profitable but have a negative cash flow and be unable to sustain your business in the near term. Similarly, you can have a positive cash flow and be unprofitable, meaning you’re not meeting your goals.
Understanding the difference between cash flow vs profit and loss (and familiarizing yourself with the other terms that go along with them) is critical. Only then can you ensure that you are bringing in enough money and managing your cash in a way that will put your business on the road to success.