The Difference Between Cashflow and Profit
Cash flow and profit can be confusing financial terms in the business world. While these two are essential to track as an owner, those new to finance and accounting find them synonymous while they truly mean two different things. The sooner they decipher profit vs cash flow, the quicker an owner can make critical decisions good for business health.
Further, when profit and cash flow are measured against each other, it becomes evident that profit has little or no correlation with the amount of cash generated. It’s easier for a small business owner to get lost in numbers that don’t make sense or are vague and not defined enough.
Interestingly, your business could be profitable, but the cash flow can be poor and vice versa. But how do you measure this? This blog post will help clear those murky financial terms regarding understanding profits vs. cash flow. Understanding these could help them avoid severe financial trouble down the road.
Let’s begin understanding the difference between cashflow and profit by understanding the two terms first.
What is Cash Flow?
Cash flow is the net money that comes into and goes out of a company over a certain period. Cash flow is crucial to every business. It’s important to have healthy cash flow for any business because it can lead to better profits and the ability to take on new projects or make investments that might not otherwise be possible.
There are mainly four types of cash flows for small businesses: Operational, Taxation, Replacement, and Expansion. And they all need to work in cohesion!
What is Profit?
Profit means monetary value. A business makes a profit when the amount of money it makes is greater than the amount of money it spends.
Profit is of three types:
Gross profit is the main difference between what the company paid to acquire a product and its cost, and the sales price. It is calculated by subtracting production costs from the final sales price.
Operating profit is the income that a company has left over from its revenues after deducting all of its operating expenses.
Operating profit = Net Income – Expenses
Net profit is the sum of the company’s revenue and its expenses. It is the company’s earnings after taking away all of its expenses but before adding or subtracting interest.
In addition, there are two basic ways that a company makes a profit – revenue generating strategies, which focus on existing or new customers, and cost reduction strategies, which focus on reducing costs or excess inventory. Either way, you will only have a profit if you make more than you spend to make that money!
Why is profit important? Profitability helps managers assess if they are earning more than their resources cost to produce and manage. For instance, a business sells a product at $20 and makes a profit (after deducting all expenses) of $2.50; he may be forced to have a different plan or strategy in order to efficiently run and grow the business.
Another thing a business does with profits is to determine whether in the short or long term they will be successful with the current action plan, and review the businesses financial health on a regular basis. Profitability provides information about companies’ efficiency because it tells how much operating profit a firm generates from its invested capital. It also indicates how effectively management has deployed that capital in developing funds before paying taxes.
How Cash Flow and Profit Interact?
Cash Flow is about cash being in or out of the company for the period; profit is what’s leftover after accounting has been done. Cash flow affects profit in ways that are independent of the company’s expenses. It implies that if you make too much money but don’t generate enough in terms of cash flow, even though your net income is high, you won’t invest more capital into growing your business.
Understand this with an example.
For example, if your profit number for the quarter shows that you have $200,000 in net income, it doesn’t tell you how much cash you have in the bank or whether your profits are real. It might look like you made $200,000 in profit, but if all those profits were eaten away by operating expenses, including the cost of buying more inventory, then you’re not making money at all.
To calculate the actual cash flow of a company, you have to figure out what portion of your profit was actually spent. Then, in the end, you take a look at how much money is really leftover. If you make $200,000 in profits and spend $150,000 on expenses before taking out any taxes or other payouts, you have $50,000 in cash flow. That’s the actual money that you can put into your pocket or payout to shareholders.
Cash flow can be both positive and negative. Examples of negative cash flow and positive profits
- You spend ample money on Research and Development. It is not an expenditure, yet it took cash out (cash outflow without any returns).
- You buy a large inventory (say for $15,000. And this happens to be the sole transaction in that fiscal year. You may not lose in profits, but it impacts the cash flow, eventually making it negative.
Examples of negative profits and positive cash flow.
- When measuring cash flow vs. net income, measure the latter by subtracting an organization’s expenses. One of the expenses is depreciation (Depreciation is when an asset loses its value over some time). It does not involve any expenditure; therefore, it is added to the cash flow statement. Suppose the same company facing depreciation of assets incurs a net loss; it will still display positive cash flow. And this is possible due to the depreciation amount added to the cash flow.
- Suppose a company sells a part of their organization, the capital thus raised would be added to the cash flow. This implies that more cash goes out than cash comes in. It impacts the cash flow. So, though it will face net loss, the cash flow would be positive for the time period.
In addition to the two above, a company may experience positive and negative cash flow in the same financial year.
Profit vs Cash Flow in Accounting
On the surface, both profits and cash flow are points in time measurements. However, they represent two different measures with very different perspectives. The difference between cash flow and profit lies in their measurement by the accountants.
Cash flow takes into account actual collections and payments made or received on an invoice. It excludes opportunities such as deferred revenues (deferred because it does not count until it’s been collected).
On the other hand, the accounting profit is based totally on what was entered. It counts receivables that have not been collected as assets even though there is no chance of getting those amounts back. Before they are written off, it allocates revenues erroneously to periods where revenues cannot be recognized according to GAAP rules.
Note: GAAP rules are a set of rules that integrate the details and complexities of corporate accounting.
Furthermore, in accounting, there are two ways you can ascertain profit or loss in a business.
- Cash basis
- Accrual basis
Cash basis accounting is a simple form of accounting. It records transactions by assuming all revenue collected on the day it was received, and expenses were paid on the day they were incurred, without any deferral recognition. It Is perfect for small business owners and freelance contractors who do not take inventory along.
For example, if a small business sells to other companies and their customers pay invoices in 30 days. The company would record the revenue when they receive payment rather than earned 30 days later on average. Similarly, expenses such as payroll are recorded. Workers are paid at payday instead of waiting until payday.
Accrual basis accounting considers revenue as earnings when received and expenses incurred, regardless of whether there is cash flow to back up these transactions on the books. If a company sells $1,000 worth of goods but doesn’t receive payment until the next year, they show $1,000 in income on their financial statement even though no money has moved through their books yet. Conversely, if you have receivables/cash “in transit”, expenses are not reported as earnings until the money is
Similarly, from the moment a company uses electricity, they would recognize it as an expense under accrual accounting. This is because even if payments for that month’s bill won’t be received until the next month, accountants still count this in their financial statements and report them to customers on every monthly invoice like normal.
If you’re looking for a way to expand your business or get out of debt, it’s time to learn the difference between profit vs. cash flow. Cash flow funds your business so that incoming revenue can be directed towards expenses and some profits. Profit is the leftover money after you have paid back all the transactions, such as any loans or debts. You need an understanding of both profit vs cash flow if you want your company to succeed. Otherwise, it will end up being wound up. Alternatively, you may consider professional help from good financial and accounting advisors.