While most businesses are consumed with turning a profit, they must not neglect cash flow.
Cash flow is critical to being able to pay your bills. Profit is the barometer most businesses use to signal achievement, but profit is not always the perfect indicator of a successful business.
The income statement can show a profit, but you might not be able to pay your vendors. On the other hand, your income statement can show a loss, but you can have money in the bank.
No one statement or calculation provides a definitive answer to whether your business has made it. No one statement should be relied on by any business owner.
Let’s look at these two concepts, why they are so vital for you to understand, and how you can use both to manage your business.
What is Cash Flow?
Cash flow refers to the money flowing in and out of your business. Inflows occur when you make a sale or sell a piece of equipment. Outflows occur when you spend money on inventory or pay invoices. A business does a balancing act to ensure that cash is always flowing.
There are several things you can do to affect your cash flow. You can sell more products or services or cut costs by searching for a less expensive vendor.
You can automate processes and either save on payroll or create efficiencies. You can obtain a line of credit or get an influx of cash by adding more money, obtaining a loan, or finding investors.
Cash flow isn’t the same as profit, but how you handle it and whether it is positive or negative can influence how profitable a company is.
Types Of Cash Flow
There are three main types of cash flow.
- Operating cash flow is cash received from normal business operations. A basic definition is net income plus non-cash expenses minus increases in working capital.
- Investing cash flow is cash generated from investment-related activities. This could be the purchase or sale of plant, property, and equipment. Investment in securities is also included.
- Financing cash flow includes money from or paid to investors, owners, and creditors. It includes money used to finance the company.
The Cash Flow Statement
The Cash Flow Statement includes a summary of all three types of cash flow.
Operating activities are calculated by taking net income and adjusting for cash generated from operating activities. These may include depreciation, amortization, income tax expenses, and other items.
Then changes in operating assets and liabilities are included. These might include accounts receivable, accounts payable, inventory, current and non-current assets, deferred revenue, and other current and non-current liabilities.
Investing activities are calculated from the purchase of marketable securities, proceeds from the sale of those securities, cash acquired, payments made for property, plant, and equipment, or purchase of intangible assets.
Financing activities include dividends, stock repurchases, and long-term debt proceeds.
These three items together increase or decrease in cash for the reporting period and will affect your financial statements. A positive cash flow means that you have cash on hand. A negative cash flow means that you have more going out than in.
A positive cash flow is good, but too much cash on hand may mean you need to invest in your company or other means to grow your business. A negative cash flow seems terrible, but you must consider the circumstances.
Purchasing inventory or equipment can result in a negative cash flow, but the effect is often temporary.
A lower sales revenue can result in a negative cash flow, but a customer might not have paid their invoice during the reporting period. When negative cash flow is repeated over several reporting periods, one needs to start worrying.
Cash flow management is key. Performing a cash flow statement regularly will allow you to anticipate problems or do some planning. Numerous months of positive cash flow may indicate it’s time to grow.
Whatever you do, don’t let your guard down. Circumstances can change quickly, and you need to be prepared.
What is Profit?
Profit is what is left when you take revenue minus expenses. It’s also the difference between what a company earned and what it incurred. Profit (or loss) is calculated on the income statement, sometimes called the profit and loss statement.
This bottom-line number is celebrated or puzzling, but it’s essential to understand the entire statement rather than focusing on one item.
If the business turns a profit, the excess can be reinvested in the business or paid to owners, investors, or shareholders. If the business is operating at a loss, it did not generate enough money from operations to cover its expenses.
Operations play a significant role in both profit and cash flow.
Profit and profitability are often used interchangeably, but there is a distinction. Profit is an absolute number calculated by subtracting expenses from revenue.
Profitability is the ratio between profit and revenue. It’s shown as a percentage. Gross profit will estimate a company’s profitability.
Types Of Profit
There are three types of profit that you should know about:
Gross profit
Gross profit is revenue minus the cost of goods sold, which are the costs incurred with producing goods. The costs must be directly related to the production of goods. These include labor and materials but do not include the rent and salaries of individuals. Gross profit measures efficiencies in your process. It will go up when your cost of goods sold decreases.
Operating profit
Operating profit is the net profit generated from normal business operations. Sometimes called EBIT, or earnings before interest and tax payments, it excludes these items and positive cash flows from outside the core business. For example, if you make a product but also rent out a space in your warehouse to someone else, that secondary piece of income would not be included in the operating profit related to your product.
Net profit
Net profit is gross profit minus expenses, but unlike operating profit, those expenses include taxes and interest payments. Net profit is a suitable parameter for the health of your business.
The Income Statement
The income statement is a core financial statement that a company must prepare. Often called the profit and loss statement, this report will show all income and expenses over a period of time.
You can see the effects of your revenue and expenses, plus your gains and losses throughout the quarter or year.
An income statement shows revenue, expenses, costs of goods sold, gross profit, operating income, income before taxes, net income, earnings per share, depreciation, and EBITDA (Earnings before interest, depreciation, taxes, and amortization).
The income statement shows investors and company leaders whether a company is poised for growth or could use some tweaks to get it back on track. It can also be used to determine where to cut spending or where to grow.
The income statement is used as a starting point to determine cash flow.
Profit VS Cash Flow: What’s the Difference?
Profit and cash flow are not the same, although many businesses feel they are. Where profit is the money left over after all expenses are paid and give you the bottom-line number and are looked at as a barometer of good financial health, cash flow is just as important to look at.
Cash flow is how money moves in and out of the business. Without cash, your business cannot function. It’s critical for businesses that want positive cash flow to look very carefully at what is received and paid.
Is Profit More Important Than Cash Flow?
Profit and cash flow are both significant metrics to consider. Examining one or the other will provide valuable information on where to focus your efforts.
A company that is turning a profit but cannot cover its payroll needs to concentrate on its cash flow. Perhaps they’ve spent a lot of money on inventory and lack funds to pay other bills. Perhaps they have customers that haven’t paid on time—either one can be corrected to improve cash flow.
On the other hand, if you are squeaking by paying all your expenses, but your company is not turning a profit, that might be your focus. You can do this by analyzing each line item, ensuring you are efficient in your production, and paying attention to every step in the process.
While it’s essential to focus on the big picture, it’s more often the little details that will make the most significant difference. Choosing a new supplier, hiring an assistant, and providing stellar customer service may affect both profit and the bottom line.
Is Free Cash Flow the Same as Profit?
While free cash flow measures profitability, it’s not quite the same as net income. Free cash flow is cash minus operating expenses and capital expenditures. It does not include depreciation and amortization expenses. Net income includes both of these items.
Free cash flow focuses more on cash reporting, while profit from the net income statement uses the accrual accounting method to calculate profit. The accrual method makes entries based on when the money is earned or incurred, rather than when it hits your account as cash.
Cash reporting looks at when you actually receive or pay the money. While this appears to be just a matter of timing, it’s important to understand when looking at your books.
Free cash flow helps investors and business owners determine whether a company is in a position to expand and if it is headed to profitability in the future.
Profit VS Cash Flow: Income and Expenses
A business can have a positive cash flow and low profit if cash comes from sources other than income. This might occur if the owner invests in their own company or uses the loan proceeds.
Conversely, a business shows a negative cash flow if the owner takes out money for an investment, pays a loan, or makes a loan to another. The way the owner reports information in their accounting system is key to understanding the difference between cash flow and profit.
How income or expenses are calculated and handled can make a huge difference in cash flow and profit.
Profit VS Cash Flow: Basis of Accounting
There are two methods of accounting, the accrual method and the cash method, and the main difference is when transactions are recorded.
Accrual Basis of Accounting
When you make entries to accounting based on the accrual method, you enter income when it is earned and subtract expenses when they are incurred.
If you bill a customer today, you will enter the item as income, but if they don’t pay the invoice for 60 days, you will not have the use of that cash. This money is counted toward your profit but is not in your cash flow calculations.
Cash Basis of Accounting
When using an accounting method based on cash, you only add or subtract entries when cash has changed hands. In the above example, you billed the customer today, and they paid 60 days later. The income would only be recorded when it hit your business account and was available for you to use.
Cash accounting does not take into account when you use credit. If a customer promises to pay, or you pay for inventory on credit, these items are not illustrated in cash flow.
You will want to use a double-entry accounting system to track these items. Each income or expense is tracked by the date incurred, and the date paid, and then there are two calculations—one for accrual and one for cash.
The Final Say
Cash flow and profit are valuable calculations, but they differ as to when income and expenses are reported.
Cash flow will tell you if you have money to pay current bills but will not tell you whether you are turning a profit. The income statement will tell you if you have a profit or loss but will not tell you how much is in your checking account.
In short, you should understand how cash flow works and each inflow and outflow involved in your business. At the same time, you should be aware of the bottom line. As a business owner, you should know about cash flow and profit and how to manage both.
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