If you are a business owner, you must understand the difference between cash flow and profit. Mistaking one for the other could be catastrophic to your business.
While a business can be highly profitable, having poor cash flow does not necessarily denote profitability, they are not interchangeable terms.
What is cash flow?
Cash flow is money that flows into, through, and out of your business during a set period. It relates to actual cash transactions and does not include credit from suppliers, money owed from clients, or cash in the bank. It only reflects the flow of funds into and out of your business.
In many cases, cash flow is used to indicate your business’s health (or otherwise) by banks, lenders or investors to assess how well your company is managing.
What is profit?
Profit is also known as “net income”, and it is the value on paper that remains from your sales revenue after all your costs have been deducted. Profit does not account for your fixed or long term assets and liabilities.
There are two main types of profit:
Gross profit is the amount of profit calculated after costs directly related to providing, creating or building your goods/services have been deducted.
Net profit is the profit made by your company after all other costs, including overheads, wages, and operating expenses such as rent, utilities etc., have been deducted.
Other Non-cash expenses, such as Depreciation, are also deducted, and Non-trading income such as Bank interest is added back to determine a company’s Assessable income for tax purposes.
While increasing profits should always be an end goal, it’s important to keep in mind that efforts to increase profitability – like introducing new products or purchasing new, more efficient pieces of equipment – may increase your expenses and push them beyond the break-even point. Not considering all costs factors could result in cash flow shortages if not managed appropriately.
What is a Break Event point?
Your Break-Even point is determined as the point at which your Gross Sales cover all your direct costs. Direct costs are also known as Cost of Sales. Profit made after your direct costs are covered is used to pay your operating/overhead expenses. Once both your direct and operating expenses have been covered, you are left with your Net Profit.
What your profit does not account for is; the timing of client receipts (how long does it take for you to get paid), your creditor payments (how quickly do you pay your suppliers), your debt and loan repayments (how much you spend on debt repayments), personal drawings, dividends and tax liabilities.
What is the difference between cash flow and profit?
While cash flow and profit may sound like the same thing, there are significant differences between the two financial parameters.
While profit is an indicator of the success of your business, cash flow may be a more discernible means of determining your company’s long-term financial outlook. The key difference between the two metrics is time.
Is cash flow more important than profit?
“Cash is King!” may be a cliche, but it’s a maxim that underpins successful business models. While you may have a profitable business with rising sales, if your cash flow is insufficient or unstable, you won’t be able to pay your suppliers on time or meet your general financial obligations. These types of events can put a grinding halt to your business.
Cash flow is the lifeblood of an organisation that keeps operations ticking over on a day-to-day basis. Cash flow management should be given top priority in your business.
Can business growth lead to cash flow problems?
While it seems counterintuitive, it is not unusual for the growth of your business to create issues with cash flow.
Rapid growth can instigate a business to struggle with either cash flow or profit, and sometimes both, from scenarios such as:
- Overspending – A suddenly successful product may cause business owners to become overly confident in their spending, such as purchasing expensive equipment. This can put a strain on cash flow and reduce your profit margin.
- Operations – if the volume of your production increases, this can change operational requirements, which may increase costs and lower profits. To keep up with increased production, you may need to employ more staff, pay extra overtime, use more power, buy more raw materials or expand your premises.
- Customer service – expanding your product range may lead to expensive warranty repairs, or product recalls, once again reducing your cash flow.
If your customer service is not suitably adjusted to meet the new demand, it may result in poor service and customer dissatisfaction, decreasing sales and corresponding profits.
Increasing your sales will often entail an initial investment in your expansion. This will require cash upfront. Any delay in receiving funds from sales will put pressure on your cash flow and needs to be carefully planned.
Regular cash flow forecasting will help you determine when cash is needed to fund your company expenses and expansion. Creating a Cash Flow forecast and monitoring your incoming and outgoing funds illustrates the difference between cash flow and profit and provides invaluable insights into when and where short-falls may occur, allowing you time to take all necessary steps to safeguard your business.
Stay on top of your cash flow management with Numble Bookkeeping
Good cash flow management is about controlling money and how it flows into and out of a business. To achieve and maintain positive cash flow, you need to work to keep your inflows higher than your outflows.
Numble can help you set up detailed cash flow reporting and look at key actions to keep your revenue high, margins profitable, and meet your financial obligations when they fall due. Numble can help your business become primed for successful growth.
Book a Free Consultation today to get started on your road to success.