The difference between cash flow and profit

Salesandprofitaretwoverydifferentthings–asabusinessowner,youcanfindyourselfwithoutthecashtopaybillsdespitemakingsalesyouknewwereprofitable.Youmayalsobestartledtodiscoverthatstrongcashflowsfromsalesdeliverlittleprofit.

What exactly is cash flow?

Acashflowforecasttrackscashflowinginandoutofyourbusiness.Thetimingoftheseflowsenablesyoutoidentifycash-richandcash-leanperiods.Thishelpsinmakingtherightdecisions,suchaswhentobuyassetsorwhentoprepareforcashshortfalls.

The importance of cash flow

Cashflowisessentialtothesurvivalofyourbusiness–arguablymoresothanprofitintheshortterm.Profitmaybeessentialinthelonger-term,butintheshort-termcashisneededtopaybillsandoperatingcosts.

For example, if you’re a plumber with good cash reserves, you can survive until your business becomes profitable. However, if your business runs out of cash, you’ll need to find a solution quickly to avoid going bankrupt.

A definition of profit

Profitisthemoneyleftinyourbusinessafterallyourexpenseshavebeenpaid.Anincomestatement(alsoreferredtoasaprofitandlossreport)revealswhatprofityourbusinessmadelastmonthorlastquarter.Yourprofit’sdetailedintwofigures,namely:Notethatnetprofitstillisn’tthefinal‘bottomline’profituntilalltaxeshavebeenpaid.

The significance of profit

Allbusinessesneedprofittogrow.Yourprofitcanbeallocatedto(amongotherpurposes):

Buying more production assets.
Developing new products, new services, or intellectual property.
Funding start-up costs for new employees.
Marketing and business growth campaigns.
Reducing debt levels.
Paying dividends to shareholders.

Why cash flow and profit can differ

Thegapbetweenacashflowforecastandanincomestatement(profitandlossreport)reflectsthedifferentwaysbusinessownersrecordfinancialdata.

Cash flow forecasts record cash

Acashflowforecastonlyrecordsactualcashtransactions.Cashflowcanbeboostedbyinputsotherthansales,suchas:

Capital injections by the owner or investors.
Cash coming in from loans.
Cash from selling an asset.

Thesesourcesboostcashlevelstofundyourbusinessbutaren’tprofit.

Profit and loss statements show actual profit

Unlikethecashflowforecast,theincomestatementincludes‘bookfigure’inputsthatdon’tinvolvecashoutlaysbutdoaffecttheprofitcalculation,suchas:

Depreciation expenses on capital assets like equipment.
Assets written down – such as writing off an uncollectible account receivable owed by a customer.

Explaining discrepancies

Thesescenarioshelpexplainthegapbetweencashflowandprofit.

Where’s the money?

“Theincomestatementshowsa$50,000profit,butthecashinthebankisonlyafractionofthis.Thefiguresdon’tmatchup.Where’sthemissingprofit?”

A common example that can raise this question is a business that buys equipment (a fixed or capital asset) for $40,000.

The cash flow forecast shows the full $40,000 cash payment when it was made.
On the income statement, the business will claim only the depreciation amount on a capital asset. However, the profit and loss account shows $4,000 as an expense against sales. This makes the business’s net profit seem much higher than the actual cash available in the bank.

Sales are great, so we must be profitable

“We’ve been extremely busy these past few months. Sales are booming – but I can’t see any profit.”

Inexperienced business owners can easily confuse ‘being busy’ with being profitable, but there’s a very clear distinction between them. Your profit is always what’s left after all costs have been deducted.

If you haven’t calculated your selling prices correctly, your ‘thriving’ business may in fact be operating at a loss. The cash flow may seem great, but the profit and loss account reveals the true picture.

The critical lesson here is to never set your prices until you know all the costs involved. You might end up operating at a loss or at an unsustainably small profit level.

We’ve made many profitable sales but can’t pay our bills

It’s quite possible to run out of cash or go bankrupt by taking on too much business too quickly, even though each sale is profitable. This is called overtrading – and businesses that sell on credit rather than cash terms are more at risk.

Actions that can lower cash flow

Reasons businesses can run out of cash include:

Excessive withdrawals by the owner(s).
Purchasing too much inventory relative to sales.
Taking on more loans than the business can service.
Buying assets at inappropriate times (such as during a slow period).
Pre-payments or paying suppliers too soon. If suppliers offer 30 days, it makes sense to take advantage of the full credit period.

Cash flow is about timing

Cash flow is all about the timing of money inflows and outflows.

If you expend significant cash to pay operating expenses and miscalculate the actual time to collect customer receivables, or your business is poor at collecting on overdue accounts, you can easily use up all your cash paying suppliers and other bills while waiting to collect amounts owed by customers.