Many business owners see profit and revenue as the same thing, but using the terms interchangeably is a recipe for cash-flow disaster. Here’s how to avoid making that mistake.
Sales are up and money is rolling in – this is what makes a business successful, right? Wrong. There is another side to the equation that actually determines how much money you’re really making from those sales and can assess whether your business is healthy.
Revenue is all the income you receive when people purchase your goods or services – in other words, it’s your sales. It does not include money you might earn from other means, such as interest. To make those sales, you have a number of expenses. They might include materials to make the products or shipping costs and other overheads like staff, warehousing and business administration. Once you factor in all those expenses, your revenue starts to look quite a bit smaller.
The revenue you earn minus these expenses is your profit. To make a profit, your revenue has to be higher than your expenses. To increase your profit margin, you must either earn more for your products and/or services or decrease your expenses.
If you are simply meeting expenses with your revenue then you’re not making a profit – you are breaking even. If it costs more to sell this product than you earned, that’s a loss. You should be able to see these figures in a profit and loss statement. Some businesses can survive by breaking even or running at a loss if there are forms of income other than revenue, but for a small business it’s a precarious situation.
How Profit Relates to Cash Flow
At its simplest level, cash flow is a cycle of money coming in from revenue and money going out to meet expenses. However, it isn’t just the amount that’s important – it’s whether the money is there when you need it. It’s no good if your account is empty when you need to order $5000 worth of stock, even if you know next week you’re due to be paid $10,000. To be cash-flow positive, the amount of money coming in must be greater than the amount going out, with the cash available at all times.
Because you’re earning more in revenue than what is going out in expenses, profit gives you cash-flow positivity by increasing the amount of unallocated money in the cycle, creating a financial buffer.
Cash Flow and Investment
The problem is that revenue rarely comes in before a business needs to pay its expenses, so most startups are cash-flow negative at the beginning. To bridge the gap, business owners either seek investment capital or a loan.
The decision to choose capital or loan will determine how soon the business becomes profitable. Why? Loan repayments are considered business expenses and must be factored as a cost, which may negate or decrease profit. On the other hand, a business is not expected to post returns on investment capital until it is profitable.
Many business owners who invest their own capital into their business end up reinvesting the profits to help it grow.
Generally speaking, a profitable, cash-flow positive business is a healthy one. It makes money for the owner but it can also service its expenses on time, reducing financial threats. Understanding the difference between revenue and profit will help business owners realise that good sales are not enough to sustain a business, but good accounting can help you get there.