Theoretically, if your business is making a lot of money, you should have a lot of cash on hand. But it doesn’t always work that way. That’s due to the difference between cash flow and profit. In order to be successful, you need to understand these distinctions.
Difference Between Cash Flow And Profit
Profit consists of your revenue minus your expenses. Imagine that your customers buy ₹120,000 worth of goods from your store in a year. During the same time period, you spend ₹36,000 on inventory, monthly bills, and payroll. When you subtract your expenses from your revenue, you have ₹84,000 in profits.
In contrast, cash flow refers to the amount of cash you have on hand. If your customers spend ₹10,000 per month and you spend ₹3,000 on bills every month, you’d have ₹7,000 cash in your bank account at the end of the first month. That is your cash flow. At the end of the second month, you have ₹14,000 in cash. But your air conditioner breaks down and you spend all that money on a repair. Now, you have no cash until more revenue flows in.
Profit Doesn’t Guarantee Cash
The above example is pretty simplified. But actual business accounting can be more complicated, especially when you use the accrual basis. Often used by large corporations and some medium size enterprises, accrual basis accounting accounts for transactions when the deal is made. In contrast, cash basis accounting (usually used by small companies) doesn’t count the funds until the money is in hand.
To explain how this highlights the difference between cash flow and profit, imagine that you own a manufacturing company and sign a deal to sell ₹100,000 worth of goods to a client. You don’t get the money until the project is complete. But because you use the accrual basis, you note the sale in your accounting records. You haven’t spent any money yet, so you have ₹100,000 in profits. You also have ₹20,000 in cash in your account from a separate deal, and that is your cash on hand. You quickly spend the ₹20,000, which brings your cash flow down to zero, but your profits are still at ₹80,000 (your income minus expenses).
At this point,you have a lot of profits on paper, but you have no cash flow. So you can’t buy any more supplies. Unfortunately, you won’t be able to finish your project unless you get money from somewhere else. But you could have easily avoided this situation if you had planned around your cash flow.
Cash Flow and Profit Reports
Imagine that you ran a cash flow report before you accepted the above deal. The report detailed your expenses and cash coming in, and you were able to easily see that you might run out of cash halfway through. To prevent that from happening, you arranged to have your client pay you the ₹100,000 in installments throughout the project.
While working on that deal, you also decided that you want to attract a new investor to your company. So, in addition to creating a cash flow report, you also created a profit-and-loss statement. That shows the investor all of your profits as well as your expenses on paper, and it gives them a clear sense of the profitability of your company.
Profit and cash flow are both extremely important. Your business needs profits to thrive, but it also needs enough cash on hand to survive. Cloud-based accounting software such as QuickBooks can help you generate cash flow and profit-and-loss reports so you have the exact information you need about your company when you need it.