Cash Flow vs Profit: The Key Difference (And Why Profitable Businesses Sometimes Go Broke)
You can be profitable on paper but run out of money in real life. This is because profit is an accounting result. Cash flow, on the other hand, deals with when money actually moves in and out of your bank account.
It’s important to know the difference between profit and cash flow for your business to thrive. Profit is based on accounting rules, while cash flow shows the real money movement in and out of your business.
Even with good sales, delays in getting paid and buying inventory can cause cash problems. Founders use simple rules to keep their business afloat while growing. These include keeping a cash reserve and managing accounts receivable well.
Key Takeaways
- Profit and cash flow are distinct financial metrics.
- Profitable businesses can fail due to poor cash flow management.
- Knowing the difference between profit and cash flow is key for business success.
- Delays in getting paid and buying inventory can lead to cash shortages.
- Keeping a cash reserve and managing accounts receivable well can help businesses stay afloat.
Understanding the Fundamentals
To understand your business’s financial health, you need to know about profit and cash flow. These terms are often mixed up, but they show different sides of your business’s money situation.
What Is Profit?
Profit is what’s left after you subtract your business expenses from your income. It shows how well your business makes money. For example, if your business makes $100,000 and spends $80,000, you have $20,000 in profit.
What Is Cash Flow?
Cash flow is about the money moving in and out of your business. It includes money from customers, payments to suppliers, and employee salaries. Remember, “Cash is king,” because even profitable businesses can struggle if they don’t handle their cash flow well.
The Critical Distinction
The main difference between profit and cash flow is the accounting method. Accrual accounting counts revenue when it’s earned, not when the cash comes in. On the other hand, cash basis accounting counts revenue when the cash is received. This can cause timing differences between profit and cash flow. Knowing these concepts is key to keeping your business financially healthy.
The Three Financial Statements Explained
To understand a company’s financial health, you need to know the three financial statements. These statements give a full picture of a company’s financial performance and position.
The Income Statement (P&L)
The income statement, or profit and loss statement (P&L), shows a company’s income and expenses over time. It shows how well a company has done financially.
Key components of the income statement include:
- Revenue
- Cost of Goods Sold (COGS)
- Operating Expenses
- Net Income
The Cash Flow Statement
The cash flow statement shows the flow of cash and cash equivalents over time. It breaks down these flows into operating, investing, and financing activities.
A cash flow statement helps you understand:
- Where cash is coming from
- How cash is being used
- The net change in cash
The Balance Sheet
The balance sheet gives a snapshot of a company’s financial state at a certain time. It lists assets, liabilities, and equity.
| Assets | Liabilities & Equity |
|---|---|
| Cash | Accounts Payable |
| Inventory | Long-term Debt |
| Property, Plant & Equipment | Shareholder’s Equity |
How They Work Together
The three financial statements are connected. For example, net income from the income statement affects retained earnings on the balance sheet. This, in turn, impacts the cash flow statement through changes in working capital.
Understanding how these statements work together gives a full view of a company’s financial health. It helps in making informed decisions.
“Financial statements are like a mirror reflecting the true state of a company’s financial health.”
Cash Flow vs Profit: Why They’re Not the Same
It’s key for business owners to know the difference between cash flow and profit. Profit is what’s left after expenses are subtracted from revenue. Cash flow, on the other hand, is about the money moving in and out of your business.
Accrual vs Cash Accounting
The main reason profit and cash flow don’t match up is the accounting method. Accrual accounting counts revenue and expenses when they’re earned or incurred, not when cash is exchanged. Cash accounting, on the other hand, records transactions only when cash is involved.
For example, if you sell a product on credit, accrual accounting sees it as revenue right away. But cash accounting waits until the payment is made.
Timing Differences
When revenue is earned and when cash is received can greatly affect cash flow. Imagine a big sale in one period but payment coming in the next. This timing can really sway your cash flow.
Non-Cash Expenses
Expenses like depreciation and amortization also play a part. They lower profit but don’t touch cash flow directly.
| Expense Type | Affects Profit | Affects Cash Flow |
|---|---|---|
| Depreciation | Yes | No |
| Amortization | Yes | No |
| Accounts Receivable | Yes | No (until paid) |
8 Common Scenarios Where Profit Doesn’t Equal Cash
Profit and cash flow are different. Sometimes, they don’t match, leading to cash shortages. As a business owner, knowing when profit doesn’t equal cash is key to managing your finances well.
Accounts Receivable Delays
When you sell on credit, you record the sale as revenue. But the cash doesn’t arrive until your customers pay. Delays in accounts receivable can hurt your cash flow, even if you’re making a profit.
Inventory Purchases
Buying inventory before selling it can use a lot of cash. Even after selling the inventory, the initial purchase drains your cash. It’s important to manage your inventory well to keep a healthy cash flow.
Debt Principal Payments
Interest payments on debt are expensed, but principal payments aren’t. Yet, these payments do reduce your cash. Large debt repayments can strain your cash flow, even if you’re profitable.
Capital Expenditures (CapEx)
Investing in new equipment or property is vital for growth. But these investments require a lot of cash upfront. This can affect your cash flow, even if they’re not expensed on your income statement.
Prepaid Expenses
Paying for goods or services in advance requires cash upfront. These expenses are recorded over time, but the initial payment impacts your cash flow.
Tax Timing Differences
Taxes owed on profits can create a gap between profit and cash flow. You might need to pay taxes before getting cash from customers. This can strain your cash flow.
Subscription Deferred Revenue
Businesses with subscription models get paid in advance. This gives a cash boost, but the revenue is deferred on your income statement. This creates a gap between cash flow and profit.
Rapid Growth Cash Squeeze
Rapid growth can lead to cash flow challenges. You need to invest in inventory and accounts receivable to support sales growth. This can strain your cash resources, even if you’re profitable.
Understanding these scenarios helps you manage your cash flow better. Recognizing the gap between profit and cash flow lets you take steps to keep your business financially healthy.
A Simple Example: Profitable But Cash Poor
Many businesses look good on paper but struggle with cash flow. Let’s look at a simple example to show this.
The Scenario Setup
You own a store that sells outdoor gear. In one month, you make $100,000 in sales. Your costs are $60,000 for goods and $20,000 for expenses. So, you seem to make a profit of $20,000.
The Income Statement View
Your income statement shows $100,000 in revenue and a $20,000 profit. But, profit isn’t the same as cash. It’s an accounting term that doesn’t always match your business’s cash situation.
The Cash Flow Reality
Looking closer, you see most sales were on credit, adding $50,000 to accounts receivable. You also bought more stock, increasing inventory by $30,000. Your cash flow statement shows a different story: despite profit, your cash went down because of receivables and inventory.
The Disconnect Explained
The gap between profit and cash flow comes from when you earn revenue versus when you get the cash. Accrual accounting counts revenue when earned, not when paid. This can make you look profitable but struggle with cash. Knowing this is key to managing your business well and keeping enough cash for bills.
Managing Your Cash Conversion Cycle
Businesses need to manage their cash flow well. The cash conversion cycle shows how long it takes to turn investments into cash from sales. It’s key for keeping a healthy cash flow.
Understanding the Cash Cycle
The cash conversion cycle is vital for managing working capital. It looks at three main parts: Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO), and Days Payable Outstanding (DPO).
Measuring Your Cash Cycle
To figure out your cash cycle, you must calculate DSO, DIO, and DPO.
Days Sales Outstanding (DSO)
DSO shows how long it takes to get paid by customers.
Days Inventory Outstanding (DIO)
DIO tells you how long inventory stays in stock before selling.
Days Payable Outstanding (DPO)
DPO shows how long it takes to pay suppliers.
| Metric | Description | Formula |
|---|---|---|
| DSO | Days Sales Outstanding | (Accounts Receivable / Total Sales) * 365 |
| DIO | Days Inventory Outstanding | (Inventory / Cost of Goods Sold) * 365 |
| DPO | Days Payable Outstanding | (Accounts Payable / Cost of Goods Sold) * 365 |
Strategies to Shorten Your Cash Cycle
To make your cash cycle shorter, work on improving DSO, DIO, and DPO. You can do this by better managing accounts receivable and payable, and by cutting down on inventory.
Practical Operating Rules for Healthy Cash Flow
Healthy cash flow is key for any business to thrive. There are specific rules to follow for this. It’s not just about having money; it’s about managing it well for long-term success.
Maintaining a Cash Buffer
Keeping a cash buffer is a must for good cash flow. This safety net helps your business handle unexpected costs or sales drops. “A cash buffer is essential for managing cash flow effectively,” as it covers essential expenses when money is tight.
Optimizing Accounts Receivable
Improving your accounts receivable is vital for better cash flow. Here are some strategies:
- Deposits and Retainers: Asking for deposits or retainers upfront can boost your cash.
- Shorter Payment Terms: Shorter payment terms, like Net-7 or Net-15, help customers pay faster.
- Streamlining Collections: Efficient collection processes ensure timely payments, reducing late or missed payments.
Strategic Accounts Payable Management
Smart management of accounts payable can also improve cash flow. This might mean negotiating longer payment terms or taking early payment discounts. By managing payables well, you can keep your cash flow healthy.
Inventory Optimization
Optimizing inventory is critical for cash flow. Too much inventory can block cash, while too little can lose sales. Using just-in-time inventory or inventory software can find the right balance.
Separating Owner Draws from Business Cash
It’s vital to keep business cash separate from personal money. Treating business cash as personal can cause cash flow issues. Keeping finances separate ensures your business has the funds it needs to operate and grow.
By following these practical rules, businesses can greatly improve their cash flow. This ensures they have the financial stability to succeed over the long term.
Creating and Using a Weekly Cash Flow Forecast
A weekly cash flow forecast is key for keeping your business financially healthy. It helps predict when you’ll get money and when you’ll spend it. This way, you can make smart choices to keep your business afloat.
Building Your 13-Week Cash Flow Template
To begin, you need a 13-week cash flow template. It should show your money coming in and going out over 13 weeks. Start by listing all money coming in, like sales and accounts receivable. Then, list all money going out, like expenses and loan payments.
Here’s a simple example of a 13-week cash flow template:
| Week | Cash Inflows | Cash Outflows | Net Cash Flow |
|---|---|---|---|
| 1 | $10,000 | $8,000 | $2,000 |
| 2 | $12,000 | $9,000 | $3,000 |
| 3 | $11,000 | $7,000 | $4,000 |
Incorporating Seasonality and Growth
When making your 13-week template, remember to include seasonality and growth. If your business changes with the seasons, adjust your forecast. For example, if sales go up in some months, show that in your template. Also, if you expect to grow, include that in your forecast.
Using Forecasts for Decision Making
A weekly cash flow forecast helps you make better business decisions. For instance, if you see a cash shortage coming, you can plan ahead. You might delay some spending or get a short-term loan.
Updating Your Forecast Regularly
To keep your forecast right, update it often. Check your actual money in and out each week and adjust your forecast. This keeps you in control of your cash flow and lets you make timely changes.
Cash Flow Red Flags: Key Metrics to Monitor
Understanding key cash flow metrics is vital for spotting financial issues early. It’s important to watch specific signs that show cash flow problems. This helps keep your finances healthy.
Days Sales Outstanding (DSO)
DSO shows how long it takes to get paid after a sale. A high DSO might mean trouble with collecting payments or customer credit issues.
Burn Rate and Runway
The burn rate is how fast a company uses up its cash. Knowing your burn rate helps figure out your runway. This is how long you have before needing more money or making a profit.
Operating Cash Flow Margin
This metric shows how much of your revenue turns into cash from operations. A good operating cash flow margin means you’re doing well in managing your business and turning sales into cash.
Current and Quick Ratios
The current ratio and quick ratio check if you can meet short-term debts. If these ratios go down, it might mean cash flow problems.
Free Cash Flow
Free cash flow is the cash left after spending on new stuff. Positive free cash flow means you can invest in growth or give back to shareholders.
By watching these key metrics, businesses can spot cash flow issues early. This way, they can take steps to stay financially healthy.
Cash Flow Management Checklist
Businesses need to focus on cash flow management to stay financially stable. A detailed cash flow management checklist helps you keep track of your finances. It guides you in making smart decisions. Here’s a checklist to help you manage your cash flow well.
Weekly Cash Management Tasks
To keep a healthy cash flow, do the following:
- Watch your cash coming in and going out every day
- Check on accounts you owe money to and those you’re owed by
- Update your cash flow forecast every week
- Keep an eye on your inventory levels
Monthly Cash Review Process
Every month, you should:
- Look over your cash flow statement
- Spot trends and any oddities
- Change your cash flow forecast if needed
- Check on accounts you owe money to and those you’re owed by
Quarterly Cash Planning
Every quarter, you should:
- Check your cash flow strategy
- Adjust your budget if needed
- Plan for changes due to seasons
- Think about investments or loans
Technology Tools to Automate Cash Management
Technology can make managing cash easier. Consider using:
- Cash flow forecasting software
- Automated accounting systems
- Online payment platforms
By using this cash flow management checklist, you can manage your finances better. You’ll be ready for challenges and make smart decisions to grow your business.
Conclusion: Balancing Profit and Cash Flow for Long-Term Success
Your business’s success depends on balancing profit and cash flow. Profit shows your company’s financial health. But cash flow is what keeps your business alive. It’s important to know the difference to make smart decisions for your business’s future.
Managing your cash flow well means keeping a steady cash flow. This includes controlling your cash cycle, having a cash reserve, and handling accounts receivable. Regularly checking your cash flow forecast helps spot problems early. This way, you can fix issues before they get worse.
Keeping profit and cash flow in balance is a continuous effort. By using the strategies from this article, you can make your business strong for the long run. Focus on building a solid financial base that supports both profit and cash flow. This will help you reach your business goals.
