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Understand the difference between cash flow and profit in running your small business

Cash Flow vs. Profit: Everything You Need to Know

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Just like your car's speedometer and tachometer, cash flow and profit are crucial gauges of your company's financial performance. People who are not experts in finance and accounting may confuse the two terms. But when comparing cash flow vs. profit, it is important to remember the differences when making decisions about your company's operations. 

In short - Profit represents the number of funds remaining after all of a small business' expenses has been paid, while cash flow refers to the net flow of funds into and out of a business over a set period, often a month.

Robust cash flow is important to maintain daily operations, pay taxes, purchase inventory, meet payroll, and cover operating costs. To achieve long-term success, a small business must be profitable while also achieving positive cash flow. Nevertheless, a company can generate a profit and still have a negative cash flow, which is detrimental to its capability to pay its expenses, expand its product line and services, and grow. Also, a company can have positive cash flow and rising sales but still not earn a profit, a common occurrence among startups and companies experiencing rapid growth.

What is Cash Flow?

Accounting includes two main methods of determining a firm's financial health and profitability. One approach is to determine the firm's accounting profits or net income. Another is to ascertain the firm's cash flow. When comparing cash flow vs. profit, the definition of cash flow is the net balance of cash passing into and out of a business at a specific point in time. 

Positive cash flow demonstrates that a company is expanding its liquid assets, i.e., assets that can be quickly exchanged into cash, such as money market instruments. Positive cash flow enables a company to pay expenses and debts, plow more money into the business, refund money to shareholders, and establish a safeguard against future financial challenges. In contrast, negative cash flow shows that a company's liquid assets are decreasing.

 Cash flow can be further arranged into three major categories:

  1. Operating cash flow: This is the net cash produced from a company's regular business operations. In actively thriving and successful companies, positive cash flow is necessary to ensure business growth.
  2. Investing cash flow: This refers to the net cash earned from a company's investment-related activities, such as investments in securities, the acquisition of physical assets such as equipment or property, or selling assets. In successful companies that are actively investing in their operations, investing cash flow may be negative.
  3. Financing cash flow: This phrase denotes how cash moves between a company and its investors, owners, or creditors. Financing cash flow can be best understood as the net cash produced to fund the company and may consist of debt, equity, and dividend payments.

Businesses usually report cash flow in their cash flow statement, a financial document intended to show a detailed breakdown of what occurred to a business's cash during a specific period.

What is Profit?

One of the most crucial aspects of small business accounting is learning the difference between cash flow vs. profit. Profit may be a better indicator of your business's success, but cash flow is vital to maintain solvency on a day-to-day basis. Profit refers to the funds that remain after all expenses are subtracted from sales. In simple terms, profit is what is left when the books are balanced, and costs are subtracted from proceeds. 

Profit provides an overall view of a business and is the basis for computing tax. For example, if a company's monthly revenue is $100,000, but expenses were $80,000, then the profit for that month would be $20,000, and the profit margin would be 20%.

Analysts examine three major types of profit: gross profit, operating profit, and net profit. Each kind of profit provides additional data about the company's performance, especially when evaluating it against other time periods and industry rivals. All three types of profit are listed on the income statement, which is explained on the U.S. Securities and Exchange Commission (SEC) website.

Gross Profit

Gross profit is defined as the costs of goods sold (COGS) subtracted from revenue. For example, if you manage a retail store or other small business, COGS is the cost of inventory sold in your store. Gross profit includes variable costs, i.e., costs that vary as a company changes the quantity of the goods or services that it manufactures or provides. Examples of variable costs also include direct labor, materials, depreciation, and production.

Gross profit does not include other fixed costs that a company is obligated to pay regardless of output, such as rent and workers' salaries who are not directly involved in producing a product. As a result, gross profit provides a strong indication of the company's financial management and overall ability to control the cost of labor and supplies during the manufacturing process. 

A small business can improve its gross margins in two ways: First, is to raise the prices of their products or services, or to lower the costs of producing its goods or services. A company can reduce the cost of manufacturing by using economies of scale or implementing production management. To calculate gross profit, take sales, deduct the cost of goods sold, and divide by sales.

Net Profit

Net profit is the net income after all expenses have been subtracted from all revenues. Net profit is considered a more accurate indication of a business's profitability than gross profit because it includes liabilities beyond COGS. To calculate net profit, subtract COGS, operating expenses, and interest and taxes from sales. 

Operating expenses include payroll, rent on a retail space, loan payments, and any other expense not directly credited to the production of a company's goods and services. Interest and taxes include federal, state, and local income and payroll taxes and any interest owed on business debt such as a business loan.

If a company generated $100,000 of post-tax income on $1 million of sales during a quarter, the net profit margin would be 10%. Also referred to as the bottom line, investors will examine it closely to judge a company's overall profit performance. A large net profit ratio indicates that a small business has excellent financial management. Companies that have achieved a sizable net profit margin have a larger safeguard to protect themselves in a downturn.

What is the Difference Between Cash Flow and Profit?

In comparing cash flow vs. profit, it is essential to remember that they are two different financial yardsticks, both of which are crucial for managing a successful small business and proper corporate accounting. The U.S. Small Business Administration advises that "the most critical consideration for the financial security, stability, and growth of your company is the control of cash."

When examining the difference between cash flow vs. profit, it is important to examine the source of the cash transactions and the accounting rules. A company can experience positive cash flow without generating profit if the cash originates from sources other than income, i.e., if owners invest their own money or other resources into the business or if they obtain a loan. 

A company can also exhibit negative cash flow while posting a profit if the owners remove cash from the business to pay personal expenses or utilize the funds to make investments or loans to others. These transactions are not income but rather liability or equity transactions that appear on the balance sheet.

A company can earn revenue, but it does not always boost its cash right away. In addition, having an expense does not always decrease cash straight away. At times, your small business's gross sales can increase, even though your business has more cash outflow than inflow. 

To monitor profits and overall cash flow, it is important to regularly review your financial statements for proper financial management. These statements include the income statement, cash flow statement, and balance sheet. Together, they provide a greater understanding of your small business and help you better comprehend how cash flow, profits, and revenue are connected.

How Accrual vs. Cash Accounting Affects Cash Flow and Profit

A business can have positive cash flow without being profitable if the cash is originating from sources other than income, such as when an owner invests their own money into the company or takes out a loan. These transactions are not income but are recorded as a liability or equity transactions on the balance sheet.

On the other hand, a company can have negative cash flow while generating a profit if the owners remove funds from the business to pay personal expenses or for investments or loans to others. These cash transactions are also recorded on the balance sheet, not the profit and loss statement.

The difference between cash flow and profit originates in the source of cash transactions and the basis of accounting. The basis of accounting is the method that revenues and expenses are recognized in the business's financial statement. The two main methodologies are the cash basis of accounting and the accrual basis of accounting.

Accrual Basis of Accounting

In comparing accrual versus cash accounting, the main difference is that businesses log income in the ledger book as soon as they present an invoice to a customer, even if it is not paid right away. Likewise, when a company receives a bill, it is acknowledged as an expense even if a business may not pay it for a month or more. Accrual accounting is much more common than the cash method. 

Accrual accounting's advantage is that it provides a more precise sense of profit and expenses over a fixed period, even if no money is exchanged. It gives the small business a much more accurate, long-term picture of the company and financial records than cash accounting. 

The disadvantage of a company using accrual accounting as its basis of accounting is that it does not provide a precise indication of cash flow. In fact, a business can seem like it is generating profits even though it has no money in the bank. That is why accrual basis accounting requires careful expert financial management and observation of cash flow to avoid serious problems.

Cash Basis of Accounting

Cash basis accounting's advantages include its simplicity, and it also lets the owner ascertain how much money the business has in its accounts at all times. For an example of how cash-based accounting would record revenues, let us study a small office supply business. Customers typically pay their invoices for paper supply and printer toner in 30 days. The company would record revenues from sales when the payment is made, a month after it sends out the invoice.

For small companies conducting business mainly through cash transactions and without large inventories, the cash accounting method can be a useful and dependable way to track revenues, profit, and expenses without the need for complex bookkeeping services. 

With cash accounting, the business only pays tax on revenue that has been received, instead of invoices that have been sent to clients and not yet reimbursed, which can boost cash flow. However, not all businesses can utilize cash basis accounting for tax purposes

Many small businesses opt to use the cash basis of accounting because it is simple to maintain, it is similar to tracking personal finances, and there is no need to contract accounting services. It is easy to determine when a transaction has occurred — the money either has been deposited in the bank or has been deducted from the account. Also, it is not necessary to track accounts receivable or accounts payable.

How Rapid Growth Can Cause Business Failures

Rapid growth can cause a business to have problems with either cash flow or profit, and even both. It can also create other accounting issues that negatively impact both cash flow and profit. In comparing cash flow vs. profit, there are several instances when rapid growth can cause a small business to fail or to struggle.

If you obtain several large orders for your product or service in a short time, that can quickly alter your operational requirements. As a result, your costs may rise, and it may lower your profits. If you don't adapt to these changes in a timely fashion, it can reduce your production, and in turn, decrease your cash flow.

New products can generate higher sales, but it can lead to expensive warranty repairs or even product recalls, which can lead to a reduction in your cash flow. You may also not be able to expand your customer service staff as quickly as your sales growth, which can cause customer discontent and complaints. Upset customers lead to lower sales and profits.

A successful product may convince your small business to make over-enthusiastic spending decisions, such as expensive equipment acquisition and unnecessary facilities upgrades. These outlays can lower your profit margin and take away the cash flow that is needed for other expenses. If you tapped debt to expand your company, you could decrease your profit and cash flow.

In some instances, it may be prudent to slow growth or postpone expansions to assure your business's financial stability and long-term success.

Understanding the differences between cash flow vs. profit will enable you to manage your small business's accounting more responsibly and boost your company's growth.

All Businesses Will Experience Cash Flow Problems From Time to Time

Managing the inflow and outflow of cash of a business is one of the most difficult challenges a business owner faces. Since there are so many variables to track (payroll costs, operating expenses, fixed asset purchases), a lot of business owners are not tracking this properly and it can cause major problems for them.

At Punch, we make sure you are regularly receiving cash flow statements and reviewing them with an experienced CFO. We analyze your cash inflows and outflows to provide you with your financial position timely. Our goal is to help you understand how your money is being utilized and how efficiently.

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