Many business owners use the terms profit and cash flow interchangeably. However, they measure two very different aspects of your business. Understanding the difference can help you make better decisions about spending, growth, financing and day-to-day operations.
What Is Profit?
Profit is what remains after your business’s revenue is reduced by its expenses.
Revenue – Expenses = Profit
For example, if your business generates $500,000 in sales and has $450,000 in expenses, your accounting profit is $50,000.
Profit is reported on your income statement and provides an important measure of how well your business is performing financially.
However, having a $50,000 profit does not necessarily mean you have $50,000 available in your bank account.
What Is Cash Flow?
Cash flow is the movement of money into and out of your business.
Cash comes into the business from customer payments, financing, owner investments and other sources. Cash leaves through expenses, supplier payments, payroll, taxes, loan payments, equipment purchases and owner withdrawals.
This means a business can be profitable but still experience a cash shortage.
How Can This Happen?
Suppose your business makes $100,000 in sales, but customers still owe you $40,000. Your income statement may show the full $100,000 of revenue, but you have only collected $60,000 in cash.
If you have $80,000 of bills due, you could have a profitable business but not enough cash to pay your obligations.
Factors That Affect Cash Flow
Several factors can cause cash flow to differ significantly from profit:
Accounts Receivable: Slow-paying customers tie up cash in unpaid invoices. The longer customers take to pay, the greater the pressure on your cash flow.
Inventory: Purchasing inventory uses cash immediately, but the cost may not become an expense until the inventory is sold. Excess inventory can therefore tie up substantial amounts of cash.
Accounts Payable: Supplier payment terms can temporarily improve cash flow. You may record an expense before actually paying the supplier.
Capital Purchases: Buying equipment, vehicles or other long-term assets can create a large cash outflow. The purchase may be recorded as an asset, with the expense recognized over time through depreciation.
Loan Payments: Loan payments generally include principal and interest. Interest affects profit, while principal payments reduce the loan balance but generally do not reduce accounting profit.
Taxes: Income taxes, GST and other tax obligations can create significant cash requirements that do not necessarily occur at the same time as the related revenue or expense.
Owner Withdrawals and Dividends: Money taken from the business can reduce available cash without necessarily being recorded as an operating expense.
Why Both Matter
Profit tells you whether your business is generating earnings. Cash flow tells you whether you have the money available to meet your financial obligations.
A profitable business can run into financial difficulty if too much cash is tied up in receivables, inventory or investments. Conversely, a business can temporarily have plenty of cash because of borrowing or owner investment while still operating at a loss.
The Bottom Line
Monitoring both profit and cash flow is essential to maintaining a financially healthy business. Regular financial statement reviews and cash-flow forecasting can help identify potential cash shortages before they become serious problems.
Need help understanding your business’s financial position? At New Heights Accounting we can help you analyze your financial statements, identify cash-flow issues and develop strategies to improve your business’s financial health.
If you are interested in having an accountant work for you give us a call.
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