As a small business owner, you can’t ignore the numbers. After all, the numbers are what keep you in business! Many figures on your income statement illustrate the overall financial health of your company—and help in forecasting future needs. Among terms like revenues, operating expenses, and losses, you’ll also take note of cash flow and profit.
Although cash flow and profit may sound similar, they have distinct meanings and impacts on your business, both short- and long-term.
So, what is the key difference between cash flow and profit?
- Cash flow is the amount of money moving in and out of the company.
- Profit is the income remaining after paying expenses.
Business owners will see that finding ways to increase both cash flow and profits over time will create a financially healthy company.
Small Business Cash Flow: Definition
Your company’s cash flow refers to the sums of money “flowing” in and out of the business. You may experience cash flow positive, in which the business’ liquid assets (aka money that’s readily available as cash) are increasing. If you have cash flow negative, liquid assets are decreasing.
In general, a company needs positive cash flow in order to pay the everyday expenses of running a business. This can include essentials like employee payroll, paying off debts, reinvesting money back into the business, and returning money to shareholders.
Types of cash flow to consider
There are several types of cash flow you’ll need to understand and monitor as a business owner:
- Cash from Operating Activities: Also known as operating cash flow, this is money that is generated (and spent) by core business activities, not other investments. For example, your cash from operating activities may expense the cost of goods sold while tracking product revenue. However, it would exclude dividend payments to shareholders and interest yields on investment products. Use operating cash flow as a core benchmark of your business’ short- and long-term viability.
- Free Cash Flow to Equity (FCFE): Cash available after business reinvestments (aka capital expenditures). This cash flow figure represents the amount of money the business generates that is potentially available to distribute to shareholders. You may reinvest into your company by purchasing computer equipment, paying for employee education, and upgrading software, for example. Use whatever is left to disperse equity payouts. A positive FCFE suggests a prosperous fiscal period.
- Free Cash Flow to the Firm (FCFF): If your business has no debts, you may use FCFF to figure out how much money you have to allocate to outside investors. As referenced, this money is freely available to shareholders, but the calculations only work if you’re debt free. Shareholder value trends can help you visualize your performance on a chart and convince investors to remain committed.
- Net Change in Cash: Also called net cash flow, this refers to the change in cash flow numbers from one accounting period to the next. Net cash flow comes in three forms: Positive cash flow, negative cash flow, and steady cash flow. This helps you label your performance over time.
Small business profit: Definition
Unlike cash flow, profit refers to the money remaining once you’ve deducted all expenses from your company revenue. The three main levels of profitability are gross profit, operating profit, and net profit. All three of these figures are found on your corporate financial statement.
3 types of profit to consider
- Gross profit: Revenues minus the cost of goods sold (COGS). Gross profit is a very basic measure of profitability, without much nuance. It’s the grand total, if you will. Use this as a starting point, but don’t base your long-term success on gross profit alone.
- Operating profit: Net income from primary business operations. Operating profit can be calculated by starting with revenue, then subtracting COGS, operating expenses, depreciation, and amortization costs. You may also see this referred to as operating income. (It does not include income from investments in partial stakes of other companies.) A slightly more nuanced metric, operating profit can help you aim for a future with more generous margins, even if you’re operating without a profit in the beginning.
- Net profit: Earnings before interest and taxes (EBIT), minus interest expenses, income tax, and other taxes. A company’s net profit takes the details a step further than operating profit. Sometimes called the bottom line, net profit starts with earnings before interest and taxes, then subtracts those expenses. Creditors may use net profit to assess business health.
Important: Some companies may present operating profit in order to provide a more favorable impression of its financials. For example, if your business carries a lot of debt, operating profit may be positive while net profit demonstrates net losses. Net profit reveals a clearer picture of company profitability and the amount of cash available for reinvesting in the company, paying off debts, and funding growth.
In general, your profit margin is a measure of how much income your business generates as a percentage of its revenues.
Cash flow vs. profit: When each one wins
Ways in which cash flow is more important
When considering which of these two metrics of business success is more important, remember that they both matter. However, cash flow has several essential attributes that suggest you should prioritize it in certain instances:
Without cash flow that’s not tied up in hard assets or accounts receivable (aka outstanding invoices that others have yet to pay your business bank account), a business can’t pay employees and suppliers.
Any small business relies on cash flow to pay staff, taxes, and regular operating expenses, as well as purchase inventory. Cash flow is also used to fund dividend payments, reinvestments into the company, future growth, and other financing activities.
Even if your business is turning a profit, that does little to help with day-to-day operating costs if that money is not liquid (aka cash in hand that can be used to pay employees, suppliers, and vendors). Cash flow represents the company’s liquid assets that are accessible for those necessary expenditures.
Hear from Calloway Cook, president of Illuminate Labs, on how he handled cash flow in the early stages of his supplement business:
“At Illuminate Labs, one of the ways we optimized cash flow in the early stages was to hire contractors rather than full-time employees. This allowed us to pay contractors on our schedule rather than be obligated to pay them on a fixed basis.”
Besides the impact of cash flow on how your company runs, it also is an important metric for potential investors and lenders. When seeking investments, your cash flow can indicate to potential investors your cash management and ability to pay dividends.
The varying measures of cash flow are useful metrics to help calculate the value of a business. Cash flow can be used to calculate these figures and more, like:
- Net present value
- Internal rate of return (for an investor)
- Liquidity (ability to meet short-term financial obligations)
- Cash flow yield (how much is generated per share as a percentage of share price)
- Cash flow per share
Ways in which profit is more important to your small business
In the short-term perspective of a company, cash flow appears more important. That’s how you keep the lights on and keep paying employees to do their jobs. However, you can have positive cash flow and increased revenue, but if too much of the business’s assets are tied up in debts and liabilities, your profit suffers.
Eventually, a lack of profit in your company will harm the cash flow aspect. A small business relies on profit to keep the cash flow going. Turning a profit is crucial to the long-term success of a small business, and your profit margins can demonstrate overall financial health.
Again, how your company chooses to present profits (such as to potential investors) can impact how fiscally sound it appears. But make sure you are working with you accountant on applying the right accounting principles. Using the metric of net profit margins may make your small business look more robust. Full disclosure of how you calculate your profit margins give more confidence to your potential investors
Still, forecasting future success depends on all forms of company profit.
Bosco Chan, Tillful’s CFO, also offers up this insight for new businesses that may not be making a profit yet:
“Having no profit (or having a loss) in a manageable, finite time with a clear business plan to achieve profitability is okay, as long as the owner or business manager has certainty of cash coming in from outside of the business to fund the period of no or negative profit. Companies do not declare bankruptcy due to no profit but they file for bankruptcy (Chapter 11) due to lack of cash.”
What to do to improve cash flow or profit as a small business owner
According to Ann McFarren, CEO of Glamnetic, “Once you have established cash flow, that is where you can dive more into the profitability of your business in the future.” But how do you go about this?
Most businesses go through periods where cash flow or profits decline. This doesn’t mean it’s all over. If your cash flow statement indicates excessive cash outflows and low cash inflows, there are some remedies.
To alleviate negative cash flow, a business owner may take out a small business loan as a bridge to get through tough times. Using a small business credit card for a brief period of time may also assist while working towards a positive cash flow.
If profits are lagging, there are plenty of routes to take to increase those figures. Find new customers, try new marketing techniques, raise prices, add new products and services, or cut expenses. Small businesses can use one or all of these methods to raise profits. Plus, many of these strategies could also be employed to help increase cash flow.
Final word: Cash flow and profit bring unique benefits to small businesses
In a perfect world, business owners will enjoy increasing cash flow and profitability at the same time. Both of these metrics are important in evaluating your small business and forecasting its growth for the future—each for different reasons.
Whether cash flow or profit is more important to your small business depends on the circumstances at any given time. Ultimately, it’s best to strike a balance between these two complementary objectives for the sake of your balance sheet.