For small businesses, cash is king. When there’s money in the bank, it can feel like the business is booming and you can tackle any challenge. And when it’s not, tough sacrifices may need to be made.
It doesn’t matter how much revenue you are owed, if you don’t have cash flow, you can’t keep a business afloat, says Marty McCaffrey, founder of Ledger General, an accounting, tax and advisory services firm in Chicago. But at the same time, cash flow alone does not prove that a business is earning a profit.
This is where many small businesses make mistakes. “Unless business owners come from a financial background, many assume that all cash flow is profit,” McCaffrey says. “But cash flow and profit are not the same thing.”
Understanding the difference could save your business.
What is cash flow?
“Cash flow is simply the money flowing through the business,” explains Suzanne Vanzant-Ladas, co-owner of ABCD Accounting, a public accounting firm in Miami, Florida. It is defined as the difference between the amounts of cash coming into and out of your accounts during a specific period of time.
Cash flow is tracked in a cash flow statement that records all sources of cash received and spent over that time. The statement should be organized under three categories:
1. Cash from operations. This section includes all revenue generated and all operating expenses including depreciation of assets.
2. Cash from investment. This section includes any cash acquired or used for the purchase or sale of assets or other investments.
3. Cash from financing. This section covers cash flow related to transactions for long-term funding, including the sale or repurchase of company stocks, and debt repayment.
The sum of all three categories is your cash flow for that period.
“Cash flow is used to determine how well the business manages its short term cash and how well it can pay its bills,” says Robert Allman, co-owner of ABCD Accounting.
Why is cash flow important?
By monitoring cash flow, and comparing cash flow statements over time, business owners can identify trends, align payments to ebbs and flow, and avoid financial choices that will lead to a financial crisis. For example, if the cash flow statements show the company always has a cash flow crunch in April, the business can proactively bank additional cash, or pay bills early to cover that gap.
“Cash flow is the lifeblood of your business,” says McCaffrey. “It doesn’t matter if a business is profitable or not, if you don’t have cash to pay your bills you won’t stay in business.”
Though, cash flow alone doesn’t tell you the whole financial story, and can be seen as a lagging indicator of financial health. Revenue payments are typically made months after goods are manufactured and sold, or services are rendered. Similarly, purchases made on credit won’t impact cash flow immediately, but will affect future cash flow and bottom line results.
A company’s profitability, when viewed in combination with cash flow, provides a clearer and more accurate picture of financial health.
What is the difference between gross and net profit?
Gross profit is the revenue you make on specific product or service by subtracting the cost of producing that good from the revenue generated. If a widget costs $50 to make and you sell it for $100, your gross profit is $50.
Gross profit is a useful tool to see which of your products or services are most profitable, how much profit you are making off of these products, and where in your business revenue is being generated (or lost). However, gross profit is not a measure of your company’s profitability.
“Net profit is the number that tells you whether your business is profitable or losing money,” says Jane Spradlin, shareholder with Concannon Miller, a tax and accounting firm in Bethlehem, Pennsylvania.
Net profit (also known as net income) is determined by calculating your gross revenue during a specific period, then subtracting all operating costs, including cost of goods sold, payroll, rent, utilities, taxes, loan repayments, and any other expenses paid. “That is how you find your bottom line,” she says.
How do I calculate my profit margins?
A company’s net profit margin is the percentage profit it is making on the sale of all goods and services, after subtracting all costs. You can determine profit margin by dividing net profit (see above) by the amount of revenue generated.
For example, if your company generates $100,000 in revenue during a specific period, and spends $80,000 in expenses, the formula is: (100,000-80,000) ÷ 100,000 = 20% profit margin.
“Understanding profit and profit margins tells you whether your business is viable,” McCaffrey says. Business owners can also use these numbers to set competitive product prices, determine salaries, and to support decisions to hire more people or invest in equipment or property. “If you know you are profitable you know what you can afford to do.”
Both cash flow and profit important measures of financial status for a business, but each one provides a different perspective on the financial health of the business. “Cash flow is how you pay your bills on a day to day basis,” Vanzant-Ladas says. “While profit is an indicator of success.”
This article is intended for general informational purposes only and does not constitute legal advice or an opinion on any issue. It should not be regarded as comprehensive or a substitute for professional advice.