What’s more important, turning a profit or being able to pay your bills? Is cash flow more important than profit? Many would say that if you turn a profit, you are set, but that’s not necessarily the case. That profit may be based on factors that are not sustainable.
On the other hand, if you continually have positive cash flow, you will likely turn a profit in the near future, even if you are not turning one now. So, while the profit number is a barometer of success, the daily influx and outflow of cash might deserve more of your attention.
We’re going to examine several types of cash flow and profit. Then, we’ll look at how you are reporting your accounting numbers makes a difference in your financial picture. Finally, we’ll come back to cash flow and profit and which one you should focus your attention on.
Cash flow is the flow of cash into and out of a business, while profit is the money left over after all expenses have been paid. Many look at a business and ask if it is profitable.
There is a celebration if the number on the income statement is positive. If the number is a loss, there’s a concern.
But cash flow and profit provide different pieces of information. A profitable company might have equipment and property which add a lot of value, but if they can’t pay their monthly bills, they are not particularly healthy.
On the other hand, if a company pays its invoices each month but does it while racking up a significant amount of debt, it might fail to show a profit.
Cash flow can be slightly manipulated. If a company receives revenue from its clients but fails to pay its suppliers, it will show a positive cash flow.
If the company invests money in a new piece of equipment, this outflow can reflect a poor cash flow for this month, but all indications are that the company invested in its future, which will pay off in the future.
Looking at all three financial statements to determine whether a business is performing well is essential.
The Statement of Cash Flows looks at where cash is coming from and going.
The Income Statement shows profitability, and the Balance Sheet shows the relationship between assets and liabilities.
Profit is the result of revenues minus operating expenses. Profit can be reported as positive or negative (or as a loss). It can be reinvested back into the company or paid to shareholders as dividends.
The way to calculate profit is through the income statement, which is also called the profit and loss statement.
There are three types of profit—gross profit, net profit, and operating profit.
Net sales minus cost of goods sold is gross profit. The cost of goods sold is the materials and labor associated with producing a product. Fixed costs such as rent and employee salaries are not included.
Gross profit involves a lot of variable costs that might fluctuate over time. As a result, minor adjustments can affect this number.
If your gross profit is not positive or not as positive as you’d like, look at equipment and how it is depreciated, direct labor, the cost of materials, utility costs, shipping charges, and credit card fees—to name a few.
This type of profit can also be used to calculate gross profit margin, which measures efficiency over time. The formula for that is revenue minus cost of goods sold divided by revenue. Comparing several numbers over time provides trends to work with.
Operating profit is very similar, except operating expenses are subtracted from net sales in addition to the cost of goods sold.
Examples of operating expenses are sales commissions, benefits, pension plans, legal fees, office supplies, property taxes, repair costs, travel costs, and marketing costs.
Net profit is all revenues minus all expenses, including taxes and interest payments.
Net profit illustrates the ability of a business to make more than it spends. It can also be used to plan your business’s expansion or decide where to make cuts.
Net profit indicates profitability. It affects your ability to get a loan as it illustrates whether you will be able to pay your debts.
Cash flow is cash moving into and out of your business. Cash moving into a business includes sales from products or services, income from the sale of stock, land, or equipment, or investment income.
Cash moving out of a business includes paying employees’ salaries, purchasing inventory or supplies, and paying rent and utility bills.
There are three types of cash flow:
Cash is reported on a Statement of Cash Flows. The resulting number is a positive or negative cash flow.
Income and expenses are two cash transactions performed during the course of doing business. Where these cash inflows and outflows originate defines whether a company will turn a profit.
For example, if a company has a lot of financing, it may show a positive cash flow, but if that money comes from the owner’s pockets, it is shown as equity transactions rather than income.
As a result, the company might show a profit but have a poor cash flow.
Same scenario if the owner of the company takes out money to pay personal bills rather than reinvesting it into creating more products and services. You will see a negative cash flow.
A company can use two forms of accounting to report its financials—on an accrual basis or a cash basis.
Depending on which one is used will affect the amount of profit shown on the income statement.
The accrual method reports revenue and expenses when they are incurred, as opposed to when the money hits your bank account.
Once you complete a service, you’ve technically earned money, so you add it to your books.
However, if the client decides not to pay until next month, you do not have that money to work with.
The accrual method provides better business performance tracking, and it’s easier to see how profitable you are each month.
Investors and lenders often require the accrual method because it’s easier for them to determine whether you are a good investment.
Because the accrual method provides fewer details, it can be harder to pinpoint problems as they arise.
You may also end up paying taxes on the income you’ve earned before you have cash.
Publicly traded companies must use the accrual method of accounting, but many businesses track their income and expenses on a cash basis.
IRS requires consistency, so if you start with one accounting method, you need to stick to it.
Using the cash basis of accounting, your income and expenses are recorded when the money is received or paid.
If you did work for a client for one month and they don’t pay you until the next month, the income will show up on the next month’s cash flow statement.
Likewise, if you purchase inventory but have 30 days to pay for it, the expense won’t be recorded until you send the check.
Cash accounting tracks cash flow better because you always know what cash you have on hand.
On the other hand, profitability is harder to track as you might not be paying your invoices for the month.
The cash system also does not track accounts receivable and accounts payable—you’ll need to account for invoices and bills separately, as these numbers are required for the balance sheet.
Cash accounting is more manageable for small businesses to understand and track themselves.
There are no manual adjustments for invoices and bills that haven’t been paid.
Until your company makes more than $25 million over a three-year period, you have heavy inventory to track, or you are required by your bank or state government to use the accrual method, you can choose to use the cash basis of accounting.
There is no quick answer to this question.
Cash flow management is important to understand how much money flows through the company and is used to determine whether it will be able to pay its bills.
Profit is the bottom-line number that investors rely on to determine whether a company will thrive.
It would be ideal if one financial report definitively showed whether a company was on the right track or successful.
Truthfully, one needs to look at several reports over several periods for answers.
Profit and cash flow don’t always correlate. You could have poor cash flow and still be profitable, or you could be cash flow positive and your income statement could show a loss.
While a profitable company with a positive cash flow is ideal, the timing of income or expenses often tends to throw off the cash flow numbers into the next reporting period. That doesn’t mean you have cash issues, just cash flow issues that can change with minor adjustments.
The most important thing is knowing what each number means, understanding where cash flows, and how it affects your profit.
That being said, we will talk about the importance of cash flow and what it means.
The cash flow statement can show anomalies in your cash inflows and outflows.
For example, if your sales are steady, but you don’t show a lot of revenue coming in, it could indicate that your clients are slow to pay.
Consider changing your terms or spending more time on collections.
Positive cash flow indicates that you may have extra money to invest in infrastructure, people, or ideas to grow your business.
You can use excess cash for new equipment, marketing, or other growth opportunities if you do not have heavy debt.
If you have debt, paying these off with extra cash inflows can open up investor opportunities.
Steady cash flow is attractive to investors. It shows you are ready to invest in new growth areas and make extra money for your shareholders.
Cash on hand eliminates the need to rely on outside sources for financing.
If you do take out loans, you will get better interest rates and payment terms.
A positive cash flow also shows your ability to repay loans in a shorter period of time.
Owners and investors rely on cash flow to determine future growth.
A steady stream of revenue that exceeds expenses sets up a pattern for the future. Barring unforeseen circumstances, steady growth shows good management decisions and a sound business plan.
This brings us back to our original question: is cash flow or profit more critical to a business? Not to sound wishy-washy, but it depends on your objective at a given time.
If you are looking to get a loan or impress bigwigs on Wall Street, make sure you are showing a profit. Concentrate on cash flow if you are trying to hit payroll this month.
The two numbers are intertwined, and they are both valuable sources of information when making financial decisions.
Want to learn more about cash flow, profit, financial statements, and how to keep more of your money? Check out our plethora of financial resources here.
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