Cash flow and profits are both very critical aspects of a business. Note that for a business to be successful in the long term, it has to generate profits while also operating with positive cash flow. Cash flow and profit are both crucial financial metrics in business, and it is not uncommon for those new to the world of finance and accounting to occasionally confuse the two terms.
However, cash flow and profit are not the same thing, and it is imperative to understand the difference between them if you want to make key decisions regarding a business’ performance and financial health. For investors, understanding the difference between profit and cash flow can make it easier to know whether a profitable company is actually a good investment based on its ability to remain solvent in times of economic crisis.
For entrepreneurs and business owners, understanding the relationship between the terms can inform important business decisions, including the ideal way to pursue growth. Here is everything you need to know about cash flow, profit, and the difference between the two concepts.
Cash flow is the inflow and outflow of money from a business. It is necessary for daily operations, taxes, purchasing inventory, and paying employees and operating costs. Cash flow positive is when you have more money moving into the business than you have moving out at any given time. Cash flow negative is the opposite — the amount of money you have going out of the business is greater than the amount of money you have coming in.
Note that to determine your business’s cash flow, you will require access to a cash flow statement template. You have to start by adding up all your cash at hand at the beginning of the month and putting it in the box in the upper left-hand corner. Next, you are going to fill in your cash inflows and cash outflows—your operating, investment, and financing activities. After you input all your cash inflows and outflows, if your closing balance (in the last row) is higher than your opening balance (first row), you are cash flow positive for that month. If it is lower, your cash flow is negative. Cash flow can be further broken into three major categories:
- Operating cash flow: This refers to the net cash generated from a company’s normal business operations. In actively growing and expanding companies, positive cash flow is required to maintain business growth.
- Investing cash flow: This refers to the net cash generated from a company’s investment-related activities, such as investments in securities, the purchase of physical assets like equipment or property, or the sale of assets. In healthy companies that are actively investing in their businesses, this number will often be in the negative.
- Financing cash flow: This refers specifically to how cash moves between a company and its investors, owners, or creditors. It is the net cash generated to finance the company and may include debt, equity, and dividend payments.
Profit is more or less referred to as the balance that remains when all of a business’s operating expenses are subtracted from its revenues. It is what’s remaining when the books are balanced and expenses are subtracted from proceeds. Profit can either be distributed to the owners and shareholders of the company, often in the form of dividend payments, or reinvested back into the company.
Profits might, for instance, be used to acquire new inventory for a business to sell, or used to finance research and development (R&D) of new products or services. Note that just like cash flow; profit can be depicted as a positive or negative number. When this calculation results in a negative number, it is referred to as a loss, because the company spent more money operating than it was able to recoup from those operations. Like cash flow, profit can be further broken down into three categories:
- Gross profit: Gross profit is simply referred to as revenue minus the cost of goods sold. It includes variable costs, which are dependent upon the level of output, such as cost of materials and labour directly associated with producing the product. It doesn’t include other fixed costs, which a company must pay regardless of output, such as rent and the salary of individuals not involved in producing a product.
- Operating profit: Just like operating cash flow, operating profit refers only to the net profit that a company generates from its normal business operations. It typically excludes negative cash flows like tax payments or interest payments on debt. Similarly, it excludes positive cash flows from areas outside of the core business. It is sometimes referred to as earnings before interest and tax (EBIT).
- Net profit: This is the net income after all expenses have been deducted from all revenues. Typically, this includes expenses like tax and interest payments.
Reasons Why Cash Flow is more important Than Profit
The key difference between cash flow and profit is that while profit indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a Business. Here are reasons why cash flow is more important than profit.
Cash Flow Helps With Business Growth
Have it in mind that a steady, positive cash flow that is invested to expand your business is a far better strategy than simply hanging on to small profits. Howbeit, growth due to continual cash flow can lead to heavy profits in future. It is a sign of the long-term prosperity of the organization.
Cash Flow Indicates Operational Issues
Positive and negative cash flow fluctuations can show operational issues within your business, something that profit can’t show. For instance, if most clients delay responding to invoices or payments, the cash flow can get out of balance. This results in a situation where one month the company experiences loss, while the next month in profit. The source of this trouble lies in the incoming cash flow. Although your sales are steady, you need to ensure a steady flow of incoming payments as well.
Cash Flow Is Money at Hand to Pay Debts
Note that counting only on heavy profits and not leaving any money in the bank can increase your debts. When you don’t pay in time, the late fees and overdrafts are added up to the initial amount. However, with cash flow, you can pay off the debts and free yourself from the burden in less time. This way, the business continues to have cash in hand to decide upon future investments once the debt is paid off.
Positive Cash Flow Indicates Healthy Financial Growth
Typically, profit cannot be predicted, but cash flow helps in predicting the growth of a business. Continuous positive cash flow entails you can plan income and investments for the upcoming months as well.
Positive Cash Flow Prevents You From Having to Take On Heavy Loans
Taking large loans to manage risky investments might seem like a good idea at first but if you have poor cash flow, it can delay the repayments, resulting in an increase in interest. Positive cash flow is very imperative as it helps you to manage repayments or even prevent you from needing the loan in the first place.
Cash Flow is a Reliable Determiner of Growth
Profit cannot determine where your business stands, while cash flow can. It cannot be manipulated to show business growth when it is not the case. That’s why owners and investors prefer to determine the health of a business based on the cash flow of an organization.
Profit and cash flow are just two of the dozens of financial terms, metrics, and ratios that you should explicitly understand so you can make informed decisions about a business. By gaining a thorough understanding of key financial principles, it is possible to advance professionally and become a smarter investor or business owner. However, when determining which one is more important, it more or less depends on the business and the circumstances.