When you’re just starting out in business, it’s easy to confuse certain accounting terms. Cash flow and profit and are particularly easy to mix up. Here, we break them down individually.
What is cash flow?
Fundamentally, your cash flow is the net amount of cash that’s being moved into and out of your business over a certain period of time.
A healthy cash flow is necessary for keeping your daily operations going, paying taxes, purchasing inventory, paying employees and seeing to other operating costs.
Positive cash flow indicates that a company’s liquid assets are getting larger. Those liquid assets, i.e. cash, enable a company to settle its debts, reinvest in its business and provide a buffer against any future financial challenges.
By contrast, a negative cash flow indicates that a company’s liquid assets are decreasing.
Many entrepreneurs start businesses with the goal of turning a big profit. Yet they don’t realise that it’s cash flow, not profit, that keeps the lights on day by day.
As a business owner, you want to keep your cash flow positive. In part, having cash available (i.e. liquidity) allows you to pay for things like debts and other expenses. On the other hand, positive, growing cash flows are one sign of a healthy business. They help demonstrate that a company’s business model is working.
What is profit?
Unlike cash flow, which is simply the net amount of cash moving into or out of your business, profit is the money that remains after all expenses are accounted for. Profit is the overall picture of a business and is the basis on which tax is calculated. This is why profit is sometimes referred to as ‘the bottom line’.
There are three major types of profit that analysts analyze: gross profit, operating profit, and net profit. Each type of profit gives more information about the company’s performance, especially when compared against other time periods and industry competitors. All three levels of profitability can be found on the income statement.
- Gross profit: A company’s gross profit is the profit it makes after deducting all the costs that are directly associated with producing its products or services. Gross profit can be calculated by subtracting a business’s revenue from its “cost of goods sold”. “Cost of goods sold” refers to all expenses that can be directly attributed to the production of goods sold by a company.
- Operating profit: Operating profit is measured by looking only at core business functions, and excludes deductions such as interest and taxes.
- Net profit: This the actual profit, after all expenses of every type have been deducted.
Profitable business with a negative cash flow?
It is possible for a business to be profitable while also having a negative cash flow, because, for example, money is tied up in assets or accounts. Alternatively, increased revenue (leading to greater cash flow) can still leave a business unprofitable. This scenario may happen when there is a substantial amount of debt on the company’s books.
In extreme cases, insufficient cash flow can send even profitable businesses into bankruptcy. The reason is timing. For example, say a company produces a certain type of goods and sells them at a profit. But the product goes through a long sales process and some of the company’s biggest wholesale customers don’t pay their invoices for 3 months.
On the other hand, the suppliers that the company works with need to be paid in 15 or 30 days.
If a company gets caught between suppliers who have short payment terms and buyers who are slow to pay, a successful product with increasing sales can create a crisis in cash flow. Why? Even though the company’s sales are increasing and profitable, the company doesn’t get paid in time to pay its suppliers, or meet payroll and other operational expenses.
Which factor (cash flow versus income) is more important to your business depends on its circumstances and the time horizon being considered. If paying off a large debt, for example, then positive cash flow is crucial in the short term to keep your business liquid.
Cash, profit and business growth
Over the long term, profit is the true mark of any business’s health. Yet adequate cash flow also remains crucial. Which is why you should keep an eye on both the long-term and short-term needs of your business when managing your accounts.
Sometimes, rapid business growth can have some unexpected effects of cash flow and profit.
Consider the following:
- Payment synchronisation issues: as described above, large wholesale buyers can be slow to pay, while suppliers have shorter payment terms. Even highly profitable businesses can find themselves low on cash in this situation.
- Excessive corporate spending: the success of a product may lead a company to make overly-optimistic spending decisions, such as buying expensive equipment and making unnecessary improvements to facilities. These can leave a business low on cash, though the company remains profitable.
In short, the key difference between cash flow and profit is time. Profit can’t show you the whole picture of how your business is doing in the short term because profit doesn’t tell you when inflows and outflows of cash are coming.
On the reverse, an unprofitable business that is cash flow positive will have a hard time remaining cash flow positive for long.
With QuickBooks, it’s easy to track your business’s cash flow, profit, expenses and overall performance. With instant access to customisable reports and dashboards, understanding how your business is performing in real time is a breeze. Better yet, with the ability to schedule payments and track invoices due, you’re always in control.
Discover more free Small Business Resources at the Intuit QuickBooks Resource Centre to help grow your business in South Africa today.