Cash Flow vs. Profit: Understanding the difference
Wed | August 2022
Seeing a reflection of the hard work of your business translated into money feels fantastic. And in a strong, expanding company, you need both profit and cash flow, but they are not the same.
To manage your business finances, you need to know the difference between making and managing money. Businesses can profit while being negative cash flow, and others businesses can have a lot of cash flow but no profit to show. How can a company make a profit but not have any cash at the end of the year? To help you understand, we'll compare cash flow vs. profit.
What is profit?
After deducting the operating costs needed to generate revenue, profit is the amount remaining. Profit remains after you balance your books and subtract your expenses from your earnings. Profit, like cash flow, can be a positive or negative number. When this Calculation is negative, the company suffers a loss because it spent more money on operations than it could recoup. For example, if a business's monthly revenue is $15,000, but it costs the company $13,000 to generate that $15,000, its monthly profit margin will be $2,000.
You can use your business profits for different purposes. Some examples are the following:
Pay dividends to shareholders.
Invest in expanding capacity or entering new markets.
Finance Research and Development (R&D).
Pay for new marketing and advertising strategies.
Not all forms of profit are the same, nor do they all accurately reflect the underlying profitability of a company. There are three types of profit:
Let's find out more about the difference between the three of them.
The profit made by a business after deducting the expenses directly related to producing its goods or services is known as gross profit. You calculate your gross profit by subtracting the costs from your business's income, or COGS for short. All expenses you can directly link to creating products or services in your company can be referred to as COGS. For instance, the cost of inventory your store sells is your COGS if you run a retail business.
Operational profit solely refers to a company's net profit from its regular business activities, similar to operating cash flow. Negative cash flows like tax payments or loan interest payments are often excluded. The same holds for positive cash flow from sources outside the core business. Earnings before interest and tax is another name, or EBIT for short.
Net profit reflects your business's profit more accurately because it considers liabilities. You can determine your net profit by subtracting operating expenses, COGS, and other financial items such as taxes and interest rates.
What is cash flow?
In simple terms, cash flow is the amount of money that enters, passes through, and leaves your business over a specific period. Cash flow only considers the steady inflow of funds into your company; it excludes credit from suppliers, money owed to you, or money you have in the bank. Business owners frequently use cash flow as a metric for the health of their business, and investors continually analyze it to determine how well a company is performing.
For example, when you purchase the inventory for your business, money goes out of the company toward your suppliers. When you sell something, cash flows back into the business from your customers. And so it is with the flow of money that goes in and out of business.
Your business can have both positive and negative cash flow. A business with positive cash flow means more money coming in than going out. On the other hand, a company with negative cash flow has more money leaving than entering it.
A cash flow statement can provide the basis for evaluating the company's ability to generate cash and its equivalent, its liquidity needs, economic decision-making, and the dates on which they occur, among other things. The cash flow statement is an introductory financial statement that reports on the variations and movements of cash and its equivalents in a given period. The document displays various instances in which a business spent or received money and compares the beginning and ending cash balances.
What is the difference between cash flow vs. profit?
As you might have already noticed, there are critical differences between cash flow and profit:
Profit remains from your income after subtracting costs from it (it is your revenue).
Cash flow is the money that comes into and goes out of your company over a specific period.
Cash flow may be a more insightful way to assess your company's long-term financial future than profits because the latter will only show you the immediate performance of your business. As you can see, time is the primary distinction between the two measurements.
As a small business owner, it is crucial to remember that your company may be profitable even though its cash flow is weak when weighing cash flow vs. profit. For instance, if you're a textile manufacturer selling goods to big businesses, a delayed payment (which happens frequently) can prevent you from being able to pay your suppliers.
Even if you have a popular product with expanding sales, you could run into cash flow problems, and even though your company is profitable, it might not be able to pay its debts. So, that leads to our next question.
Is cash flow more important than profit?
Yes and no. Of course, profit and cash flow are vital to our business success, but there are key differences.
Net profit and cash flow measure different things. Cash flow, which keeps operations running daily, is the backbone of a company, even while profit is the ultimate goal and a sign of financial health. Both cash flow and net profit are crucial for a developing company, but in the short term, cash flow is likely the most significant worry and vital indicator to keep in mind.
You can use your income statement, also known as the Profit and Loss Statement; this document is a tool for your business’s finances. It consists of a financial statement where you take a snapshot of your company's revenue and expenses over a specific period. This way, you get to track both cash flow and profit.
Plan the cash flow of your company with One Park Financial.
While increasing revenues is a terrific goal, it also needs cautious planning to satisfy your company's cash requirements. Make sure you understand the distinctions between revenue and cash flow so that you can expand your company while maintaining a healthy cash flow.
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Disclaimer: The content of this post has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, or accounting advice. Consult with your tax, legal, and accounting advisor before engaging in any transaction.