Both cash flow and profit are crucial financial indicators for any business. But even though newcomers to finance and accounting get both terms mixed up, they differ.
It's crucial to distinguish between cash flow and profit when evaluating the success and viability of a business. Profit and cash flow are different measures of a firm's financial health and knowing the difference between cash flow and profit is a guaranteed way to failproof your business.
What you need to know about cash flow
An organization's cash flow is its cash inflow during a given period minus its outflow during the same time. Every company experiences a steady ebb and flow of cash. For instance, when a store pays its vendors for merchandise, that money leaves the company. When a store sells an item from its stock, customers pay. And that's money that comes in.
It's also cash flow when money leaves the company and is used to settle debts, including employee wages, company phone service bills, and energy payments. If a customer who made a purchase 12 months ago is still making monthly payments, that means money is coming into the company.
The cash flow statement is a standard financial report that summarizes and analyzes a company's cash transactions over a designated period. This report includes a company's opening and closing cash balances. In addition, it details how and why cash was spent or received.
Your company’s cash flow statement can be positive or negative depending on specific factors. Positive cash flow means more money is coming into the company than going out. Conversely, negative cash flow describes a situation where there’s more money leaving the enterprise than it's receiving.
Negative cash flow might affect your ability to improve your business by investing in training, marketing efforts or upgrading your communications infrastructure.
Common cash flow structures for small businesses
Operating cash flow
A business' operating cash flow is the money it has after paying its operating expenses. Operating cash flow is essential for a developing business to continue its expansion and growth.
Investing cash flow
This term describes the net cash a firm receives from its investment undertakings. These investments may include equipment acquisition, asset sales, or security purchases. Investing cash flow is typically negative in well-run organizations making strategic investments.
Financing cash flow
From a financing perspective, a corporation's cash flow is the flow of money from investors, owners, and creditors into & out of the company. When you streamline sales communication, you can increase those sales numbers, increasing the chances of a positive financing cash flow.
Financial cash flow is the total of all financial flows into and out of a corporation, including any equity, dividend payments, or debt.
What profit looks like
Your company’s net profit is what’s left when all the bills are paid, and expenses are deducted from sales.
Dividends are one common way a company's profit is returned to its owners and shareholders. A company's profits could also be reinvested in the company by funding product development or new inventory purchase.
The income statement is also known as the profit and loss statement. And just like for cash flow, it can be positive or negative.
The income statement is the standard format for reporting a business' financial results. This report outlines the financial outcome during a given time frame, including losses, profit, expenses, and revenue.
Investors love to interrogate profit and loss statements. While analyzing the document, they’ll ask lots of questions like, "I see VoIP costs there. What is a VoIP phone?" Therefore, ensure you can explain everything on your profit and loss statement.
Just like cash flow, it’s possible to define company profit differently:
Common SMB profit types
When you deduct the cost of goods sold from revenue, you get the gross profit. Cost expenses include the money spent on expenses like raw materials and wages that change with production volumes.
Other fixed expenditures like rent, employee salaries, and expenses that aren't directly involved in creating a product aren't included.
This profit is also known as "earnings before interest and taxes" (EBIT). Similar to operating cash flow, operating profit is a firm's net profit due to running its regular business activities.
Expenses that reduce cash flow, like taxes and debt payments, are often not included. It also doesn't account for cash inflows from somewhere besides the core business.
The term "net profit" describes the amount of money that remains after all expenses have been deducted.
Once all costs have been deducted, the remaining amount is your net profit. Earnings after tax is another name for this concept.
Net profit is especially crucial for brick-and-mortar stores to track, as rising sales aren't necessarily followed by a rise in profits, if rent or utility costs climb with them.
The difference between cash flow and profit
The primary distinction between cash flow and profit is the latter measures net inflow and outflow of cash into and out of a company, whereas the former measures only the amount of money left after expenses.
Your business being profitable doesn't necessarily mean you have cash.
For instance, let's assume you allow credit options as one of the payment methods for your business. This feature means certain customers can buy your product(s) on credit. You'll make a profit off the sale when they pay. But until they do, you don't have the money at hand.
Let's say you need to pay your suppliers every 10 days and the credit period you provide customers is one week, but, your customers default on payment. It could impact your future sales or production if you don't have the funds to pay your suppliers.
This situation clearly shows your unit sales may increase, which should indicate profit. But your cash flow isn’t enough to pay your bills on time. As a result, your creditors may coerce you into bankruptcy even if sales increase rapidly. They may not be empathetic about your inability to keep up with payments.
Likewise, your business expanding and generating continuous cash flow doesn't indicate profitability.
Let's assume you urgently need to pay vendors or buy new machinery. You may have personal funds to make the purchase. But because you understand the reasons not to mix up personal and business finance, you decide to take a loan.
The loan will give your company a healthy inflow of money. But if the interest on that loan pushes your operating expenses over the zero line, your business is no longer profitable.
Which is more important: cash flow or profit?
Most times, shareholders and business owners look for a single indicator of firm health. For example, their ideal PandaDoc financial proposal template would have a specific KPI that would tell them whether or not to make an investment or change course.
Which should be prioritized between cash flow and profit in the above situation?
Both profit and cash flow are critical in their own right. Therefore, there is no easy answer to the above question. If you're an investor, business owner, employee, or entrepreneur trying to assess a company's financial health, you must be familiar with both variables and their interaction signals.
For instance, it's possible for an e-commerce business to be making money but lack enough cash on hand to cover its costs. Now you’ll have to scale back your e-commerce marketing which could impact future cash flow.
In a similar vein, many young and expanding businesses struggle to realize profit despite increasing both their cash flow and their sales. This drawback is one of the reasons we recommend considering customer lifetime value before making any important business decisions.
Cash flow and profit are not the same
Both cash flow and profit are vital to a business, with cash flow representing the cash-on-hand you have to make moves in the here and now, while profit is what you’re left with when all is said and done.
You need to know exactly where you are, with both measures, to make sound financial decisions. Growing a business is about manipulating these levers, spending a little now to increase profits later, or scaling back when your cash flow is low, to protect the business over the long term.
John Allen is the director of SEO at cloud-based business communications services company 8x8.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.