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Tracking cash flow and profit may offer insights into your small business's financial health. It might be easy to confuse these two terms, since they both measure financial performance, though they do it in different ways. Profit reflects earnings after expenses, while cash flow measures how money moves in and out of the business.
Understanding the difference between cash flow vs. profit could help you better manage your business's liquidity, implement growth plans, and avoid financial shortfalls.
What Is Profit?
Profit is the money that remains after a business's expenses are deducted from its revenue. One way profit can be calculated is with the accrual method, which calculates profit by recording revenues when they are earned and matching them with expenses when they are incurred. What is profit, in terms of its importance as a financial metric? In short, it may be an indicator of business performance and long-term sustainability.
Maximizing profits may begin with understanding the different types of profit small businesses measure.
Gross Profit
Gross profit represents revenue minus the cost of goods sold (COGS). For example, if you produce a product for $50 and sell it for $100, your gross profit is $50. Businesses may analyze gross profit margins to evaluate pricing strategies and production costs.
By monitoring cash flow vs. profit and comparing cash-flow statements over time, businesses might be able to better anticipate changing cash-flow needs.
This metric might tell you which products or services are most profitable, how much profit you're making from these products, and where in your business revenue is generated (or lost). Essentially, gross profit may be an efficiency measure of how a business produces or delivers products before operating expenses are considered.
Operating Profit
Operating profit or operating income is the amount that remains after operating expenses are deducted from gross profit. Operating expenses may include salaries, rent, marketing, and administrative costs.
A business's operating profit could reflect the profitability of its core business operations. It may indicate whether a company might realistically generate enough income from its primary business activities to cover all of its operating costs.
Net Profit
Net profit is a business's final profit after deducting all expenses, including interest, depreciation, and other non-operating costs. This number represents a business's bottom line, and it's the metric that could be used to measure overall financial success.
A company's net profit margin, meanwhile, is the percentage profit it's making on the sale of all goods and services, after subtracting all costs. This calculation can help you find the profit margin:
(Net Profit / Revenue) x 100 = Profit Margin
For example, if your company generates $100,000 in revenue and has $80,000 in expenses, the formula is as follows: (100,000-80,000) ÷ 100,000 = 20% profit margin.
What Is Cash Flow?
Cash flow is the movement of money in and out of a business over a set period. Unlike profit, cash flow focuses on the timing of actual cash transactions.
Positive cash flow could indicate that a business is bringing in more money than it spends over a specific period; negative cash flow may suggest the opposite. Even a profitable business may experience cash flow problems if inflows are delayed or expenses come due before revenue is collected.
Operating Cash Flow
Operating cash flow measures the amount of cash generated or used by a company's core business operations. This figure may include:
- Cash received from customers
- Cash paid for operating expenses, such as inventory, wages, and utilities
A small business's operating cash flow may shed light on its operational efficiency, liquidity, and overall financial health. At a glance, it may tell you how the profits you realize on paper may translate to cash in the bank.
Investing Cash Flow
Investing cash flow reflects money spent or earned from investments in long-term assets. That includes equipment, real estate, and securities. It's may not be unusual for businesses that regularly invest in growth to report a negative investing cash-flow number. Although it does reduce the amount of cash a business has on hand, it may also suggest that the business has sufficient cash flow to support its growth goals.
Financing Cash Flow
Financing cash flow tracks money received from or paid to investors and lenders, respectively. Financing cash-flow calculations may include loans, equity investments, dividend payments, and debt payments.
A business's financing activities may affect its capital structure in several ways. For example, debt increases debt-to-equity ratios, which in turn could raise the company's risk profile. Debt repayment, on the other hand, may help reduce risk and improve the business's leverage ratio.
Positive financing cash flow may suggest a business is successful at raising capital. That may positively influence your company's brand image, as it may signal investor trust in your business. Negative financing cash flow could indicate that a business pays out more in debt than it raises in capital. However, the potential effect on your brand may depend in part on whether you're consistent in repaying what you borrow.
Key Differences Between Cash Flow and Profit
The fundamental differences between profit vs. cash flow center on what they track. Profit tracks financial performance through the accrual accounting method, which includes non-cash items. Cash flow tracks the movement of money through the business.
- Cash flow is concerned with timing. It answers the question of when money moves into the business and when it moves out again. Cash flow measures your business's ability to pay its bills, cover operational costs, and manage its obligations in the short term.
- Profit is concerned with the financial gain a business reports over a set period. It deducts total expenses from total revenue and may offer insights into how well-equipped a business is to survive in the long term.
Several factors might cause profit and cash flow to differ significantly. For example, recording revenue when it's earned using the accrual method means that profit appears on the books right away. However, the cash related to that transaction isn't available until the customer pays their invoice. Longer payment terms may mean a longer wait for cash inflows.
Depreciation, meanwhile, decreases net profit by acting as a non-cash expense on your business's income statement. Conversely, because depreciation is a non-cash expense, it may affect profit without reducing cash flow. Inventory purchases may not reduce profits right away, but they could do so over time if you're paying additional costs to store the inventory until it's sold. Buying inventory creates a cash outflow, but sales could result in cash inflows.
Running a cash-flow analysis could tell you where cash comes from and where it goes, as well as the amount of working capital you have on hand at any given time. By monitoring cash flow vs. profit and comparing cash-flow statements over time, businesses might be able to better anticipate changing cash-flow needs. For example, if cash-flow statements show a recurring shortfall in April each year, you could consider proactively banking additional cash, paying bills early, or looking at working capital financing options to fill the gap.
Why Businesses Can Be Profitable But Run Out of Cash
A company's profitability, when viewed in combination with cash flow, may provide a clearer, more accurate picture of financial health. It could also provide insights into how to convert profit into cash flow. However, it's important to remember that businesses might be profitable on paper but may lack sufficient cash flow.
For example, a company may report profits but face liquidity problems if customers are slow to pay invoices or a large inventory purchase is required to stock up on products or raw materials ahead of a busier sales period. Debt could also lead to cash shortages if a business is drawing down more of its cash flow to repay lenders.
Likewise, investing in growth could reduce cash on hand if you're using your cash reserves to fund expenses. The upside, of course, is that those growth investments may potentially help improve profitability and cash flow over time.
How to Help Improve Both Cash Flow and Profitability
Taking a practical approach could help solve cash-flow problems and potentially improve profitability.
Here are some potential solutions to consider to help improve cash flow:
- Monitor operating expenses and consider what you could reduce or eliminate to help manage your operating budget.
- Optimize inventory management so that you're timing inventory purchases close to when cash inflows will arrive.
- Invoice customers on time and allow them a choice of payment methods, including digital payment options.
- Offer a discount for early payments and charge a late fee for payments received a set number of days beyond the due date.
Here are some ideas to consider to try to improve profit:
- Regularly review your business's pricing structure relative to your competitor's to help determine whether your prices reflect the current market.
- Bundle products or services if possible to increase the average transaction size.
- Reduce or eliminate inefficiencies in your business practices, including inventory management and invoicing systems.
- Consider whether you may be able to reduce expenses by outsourcing certain tasks or utilizing software-based programs to potentially help save time and increase productivity.
Understanding the difference between cash flow vs. profit could be vital to running a successful business. Both may be important measures of financial status, but each one may provide a different perspective on the business's financial health.
Interested in more cash flow improvement strategies? Learn how tracking discretionary spending could help you exercise more control over your business budget.
Photo: Getty Images
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