Cash Flow vs. Profit – What’s the difference?
Let’s talk; bottom line. More specifically, net profit. This is the most accurate metric on business profitability as it reflects real financial health and success.
Net Profit = Total Revenue – Total Cost and Expenses
Net profit is the difference between revenues and all types of expenses. This would include costs of goods sold, such as costs of materials and overheads, as well as interest on any debt and corporate taxes to be paid.
On the other hand, cash flow is the net amount of cash and cash equivalents moving in and out of the business at any given period of time. An important cash flow formula is the calculation of free cash flow (FCF). It calculates how much cash you have on hand that is available or free to use. Moreover, it provides a snapshot of the company’s financial health so you can better understand its liquidity.
Free Cash Flow = Net Profit + Depreciation/Amortization – [Total Assets – Total Liabilities] – Capital Expenditure
Not sure if you should buy new HR software or how much you can splurge on a loyal client? The FCF will answer your budgeting questions.
Most businesses track cash flow on a month-to-month basis and show the company’s operating, investing, and financing activities within the set timeframe. For instance, a business that is expanding operations is likely to incur negative cash flow but expansion is not necessarily a bad thing.
By understanding the difference between profits and cash flow, you will also understand why it is possible for businesses to be profitable but go out of business. Let’s take a look at the financials of a hypothetical company to better understand this.
Example: Jake’s Laptop Cases
|P/L ($)||Cash Flow|
|Month 1||Month 2|
|Costs of Goods Sold||60,000||(30,000)||(30,000)|
|All Other Expenses||20,000||(10,000)||(10,000)|
In this example, Jake’s Laptop Cases made $100,000 in revenue. They have a trade credit with the retailer that stocks his products. This could be problematic if they do not have sufficient cash on hand to float operations until payment is received.
To begin manufacturing, Jake’s Laptop Cases is required to pay 50 percent of material cost upfront to their suppliers in the first month. Additionally, they have to pay the monthly interest on a business loan.
If Jake’s Laptop Cases only focused on net profit, the outlook, while good, does not reflect the realities of the business. When evaluating your cash flow, position the company to handle negative cash flow in Month 1 in order to generate revenue in Month 2 for the company to be profitable.
Cash Flow is King – Why you should pay attention to cash flow
There are three main reasons why cash flow is important and deserves your attention.
1. Avoid the debt trap
Cash flow will inform whether you are able to settle the business debt in a timely fashion or be at risk of defaulting on a loan and damaging your credit ranking. Moreover, a company can ensure they are employing debt effectively and not borrowing beyond their means. For instance, a restaurant may want to take a loan to buy a property instead of renting to reduce increasing rental overheads.
Cash flow allows you to budget how much the company can reinvest for its growth and expansion as and when necessary. You are able to ascertain if you can take on short-time expenses such as hiring a PR agency or invest in large capital expenditure, such as better equipment or new facilities.
3. Decision Making
Cash flow allows you to make critical decisions like determining how much buffer a company needs to guard against future financial challenges such as a recession. It would also inform you of the company’s financial runway and tell you if cost-cutting measures are necessary.
Running a business is no small feat. Cash flow is the lifeblood of any company and managing it undoubtedly plays a critical role in your company’s success and survival.