Mo’ Money Mo’ Problems: The Difference Between Profit and Cash Flow
You came into work this morning and saw that your business turned a profit last quarter. Congrats! But don’t break out the mimosas just yet. A business can be profitable, yet have no promising signs of cash flow. So then what’s the difference and why does it matter?
A great word, we all know what profit means for us — mo’ money! But, by definition, profit is the difference between revenue and expenses, which we also call ‘net income.’ These expenses include depreciation and cost of goods sold, so being profitable just means a company had extra money over its production costs that month, quarter, year. We also commonly use profit as a measure of a business’s success over a period of time, but the term ‘cash flow’ is more dynamic and measured on a day-to-day basis — therefore, profit isn’t the only indicator of a business’s short-term efficacy.
Obviously profit has merit for determining success or we wouldn’t focus on it so much and tax collectors wouldn’t either, since you’re bringing in more money than you’re spending on production, investing, etc., at least on paper. But, in many cases, it is equally if not more important to look at the cash flow to see whether a business is successful or not, than whether it’s profitable, because profit is really a number on a spreadsheet, and cash flow, like I mentioned, is more about day-to-day funds — cold hard cash — available to the company. Before I go on, you might be scratching your head: wait, what’s cash flow again?
Glad you asked! Cash flow demonstrates the cash coming in and going out — inflows and outflows — from a business’s operating, financing, and investing activities on a daily basis. That is, paying the electric bill, returning money to shareholders, reinvesting in the company itself. While there certainly is a cash inflow when making a profit, an increase in profit isn’t necessarily equal to an increase in cash, unfortunately. Similarly, a business may spend more in cash than what was reported in expenses. Think of this:
A company purchases $100 worth of printer ink. The company only uses half of the printer ink during the reporting period. The company has a cash outflow of $100 BUT the company only expenses $50 since that’s the economic value that has been used.
Still with me? To keep enough cash on hand and keep a business afloat, you have to understand the factors that affect cash flow, such as seasonal fluctuations and debt financing. But first, let’s talk about the fact that an increase in profit doesn’t mean an increase in cash, and why that is important to know when running your business.
Why Does this Happen?
These two amounts often differ due to something called accrual accounting, where revenue and expenses are recorded regardless of whether or not cash has changed hands. For example, say you send an invoice this month for $500 but don’t receive payment for a few months. This would still be recorded as a profit on the P&L statement, right? Yet when your bills are due that month, the tricky part comes in when you haven’t collected your receivables and you’re cash-flow negative. Profit doesn’t necessarily mean a business has cash to keep the lights on or the employees paid.
So you can see now how small businesses often cite failure due to cash flow issues – the business may be making a profit over its expenses, but the cash hasn’t come in or is stuck in hard assets and therefore the electricity gets turned off for a couple days. But we had a profit, you cry! Well, you (hopefully) understand the difference and the importance of both profit and cash flow from this brief explanation. Now you can combat this negative-cash-flow-from-hell by conducting frequent cash flow analysis, planning for gaps in AR and AP, effectively managing assets, or hiring professional assistance. We are striving to create long-term viability for your firm and understanding the distinction between profit and cash flow is imperative for that end!