What is the difference between cash flow and profit?
Profit is the goal. But without cash flow, your profits exist only on paper. Presented by Chase for Business.
- Profit and cash flow measure different things. Profit shows whether your revenue is greater than your expenses, while cash flow tracks the actual money moving into and out of your business.
- A profitable business can still face cash shortages. If your customer payments are delayed or if you have expenses due before you’re able to collect cash, your business may show profit on paper but still struggle to cover day-to-day costs.
- Looking at profit and cash flow together can help business owners manage operations, plan growth and better understand the financial health of their business.
Every business wants to be profitable, but profit alone isn’t the full picture of the financial health of your business. You also need to consider cash flow. Think of profit and cash flow as two sides of the same coin. Understanding how they work together can help you make more informed decisions, maintain liquidity and keep your business running smoothly.
What is profitability?
Businesses typically look at profit in three ways: net profit, gross profit and operating profit.
Net profit
Most people are familiar with net profit because the formula is simple: Revenue – Expenses = Net profit. But the numbers can mean different things depending on your company’s accounting method.
- Accrual accounting adds up revenue when it’s earned and expenses when they’re billed. That means a business could show revenue months before it receives the cash and expenses months before they’re actually paid.
- Cash accounting adds revenue to the books and subtracts expenses only when money changes hands.
Each method has its merits. Accrual accounting makes it easier to see relationships between revenue and expenses. It also can help you see trends as they develop. Cash accounting means you are working with solid numbers that relate to your cash flow.
Accrual accounting can get confusing when tracking cash. If cash from revenue arrives slowly but expenses are paid quickly, you could run out of cash despite showing a healthy profit on the books.
Human nature adds another layer of complexity. It’s easy for anyone to slip into “mental accounting.” After a big sale or a new contract, you might feel flush with cash, which can make you more likely to splurge on extras. But what if your customer doesn’t pay? What if payments come in late or are staggered over a long period of time? Those extra expenses could strain your resources. A profitable company can weather some payment irregularities, but if the gap between the profit you’re making on paper and the cash you’re bringing in is too large, it might affect your ability to do business.
Gross profit
Gross profit subtracts the cost of goods sold from generated revenue. This is often what people mean when they talk about profit margins on a product or service. Gross profit offers a way to compare what it costs to deliver a product with the revenue earned on that product or service. Gross profit can tell you if your markup needs an adjustment, but it won’t tell you whether you’re likely to have money in the bank each month.
Operating profit
Operating profit zeroes in on efficiency by subtracting operating expenses (including interest and taxes) from gross profits. Put another way, it looks at how well your markup covers what it costs to run your business. For example, if your operating costs are significantly higher than the costs to produce goods, you might have room to cut your operational costs, improving both operating profit and net profit.
What is cash flow?
Small business cash flow is the amount of actual money coming into and going out of your business. It’s liquidity. Positive cash flow means your bank balance is growing. Negative cash flow implies that you’re depleting your reserves. It’s important to understand how to calculate cash flow, if you want to grow your business.
Businesses often create cash flow statements so that lenders and investors can see how cash moves through a business and the potential for sustained or increased profits. These statements detail all the ways cash comes in and goes out via operating, investing or financing activities.
What’s important to recognize is that cash flow must be managed. A sale isn’t complete until your business receives the cash. And payments can be timed to prioritize specific purchases or to preserve cash until revenue catches up. Well-run businesses pay close attention to their financial operations and make informed decisions about how to collect revenue and pay bills.
Business owners who understand how cash moves through their businesses and monitor the ups and downs of their accounts can be more strategic about how they use their money, and they are less likely to be surprised by changes in the marketplace or unforeseen events.
Using cash flow and profit together
Monitoring cash flow and profit together can help you make nuanced decisions about your business and its finances. For example, if you pay yourself an owner’s draw, knowing that your profit numbers are backed by positive cash flow can make you feel confident about how much of your company’s profits to take for yourself. Or maybe you notice that cash is accumulating in your business bank account. By reviewing your profit history, you can better gauge whether now is the right time to invest that cash in expanding to a new location or increasing production.
Basically, anytime you see short-term cash flow numbers that are larger or smaller than expected, check them against your profits and vice versa. Together, the calculations can help you make smarter choices for yourself and your business.
Start with banking
A strong banking relationship is an important step toward savvy management of your cash flow and profits. Speak with a business banker to discuss which products can help you crunch the numbers and grow your business.
