Why Profit Doesn’t Equate to Cash Flow: What It Means For Your Business
To know where money has gone and where to allocate it in the future, first, you need to understand the relationship between profit and cash flow, and how each is calculated.
Understanding Profit vs. Cash Flow
- Cash flow is a term used to describe the movement of money in and out of a business. It’s a measurement of whether an organization can pay its bills.
- Profit (also known as “net profit” or “net income”) is the amount of money left after subtracting all costs associated with running your business. A business's sustainability is measured by this indicator.
It’s also worth noting that profit should not be confused with revenue. Revenue describes income generated through business operations, whereas profit describes the net income (or earnings), as defined above.
As a business, it’s important to look at these metrics both separately and together. In other words, while you can get a general idea of how much money your company makes by looking at its profit margin, it won’t tell you how much cash is available for reinvestment or distribution to owners or investors. You also won't know how much money is being spent on day-to-day operations until you look at the cash flow statement.
Related tool: Free cash flow forecasting template
Now let’s dive deeper into this relationship to give you a better understanding of the role that cash flow and profit play in your business.
Why Is It So Important to Distinguish Between Cash Flow and Profit
At a first, glance, being cash flow positive and profitable may seem pretty similar, but there is a key difference.
While profit indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a business.
As many businesses know, cash is always moving. To function, entities require operating cash flow to meet payroll, make insurance or building payments, and handle the laundry list of other day-to-day expenses to keep business running as usual.
Many businesses use the accrual method of accounting, which records income and expenses when you earn or incur them — regardless of whether the cash has been exchanged. So while you're sending out invoices, clients may not pay them for 30, 60, or more days out. Meaning, you may find yourself without enough liquidity to keep your company running.
Cash flow can be positive or negative at any given time – but does not necessarily reflect whether the business is making money. Conversely, a company could be making tons of money on paper, yet not have enough cash to pay the bills. This is the definition of insolvency. This is why poor cash management is a leading cause of many business failures.
Even if you're earning a profit today, you may not be turning those profits into positive cash flow down the road.
What To Do if You’re Making a Profit, but Have No Cash
Many businesses are profitable on paper but still lack sufficient cash on hand to pay bills. This can happen for various reasons, from rapid growth or unexpected business expenses to poor oversight.
There are a few ways to stay out of this situation:
- Pay attention to what’s going out (and when)
- Cut unnecessary expenses where possible
- Negotiate payment terms with vendors, such as changing when bills hit or the frequency of payment, based on forecasts
- Incentive customers to pay quicker, such as a discount for automated payments or penalties for late ones.
However, if you are already in a tough spot, the first step to take is to review the required expenses for operations (employees, supplies, vendors). Next, put controls in place to avoid unnecessary uses of cash.
You may need to speak with suppliers and vendors beforehand to let them know of your situation and potentially negotiate terms to satisfy both parties.
Finally, seek help from a financial expert. They can be an objective third party to help you through the lean times and ensure better days ahead. A fractional CFO or CFO consultant may be a great fit, as they can act as an advisor without the overhead and expense of a full-time employee.
The bottom line: profits do not keep a company in business – cash flow does. Positive cash flow enables a company to reinvest in itself and grow without financial trouble.
Consider hiring a fractional CFO or Controller
Profits and cash flow are just two of the dozens of financial metrics and terms that every successful entrepreneur needs to know. By becoming familiar with these concepts, you can better understand your company, make more informed decisions and set yourself up for success.
But nothing can compare to the expertise and skill of a trained financial advisor. Contact us today and we can get you on the right track. We can work alongside your existing accounting team, streamline financial processes and not just share financial data but interpret it for the benefit of your business.