The difference between cash flow and profit explained
While profitability is often the most popular figure brought up when someone asks about a business’s health, it’s not always the best indicator. To truly discover how a business is doing today — and where it’s headed — you must also consider cash flow. Knowing the difference between the two is crucial to maintaining a sustainable operation.
What is cash flow?
Cash flow is a measure of the money coming into your business, usually in the form of revenue, and the money leaving it, usually as expenses. Cash flow is one of the most important figures to consider when evaluating a business as it shows how a business is both earning and spending its money.
Incoming cash flow is what keeps a business’s day-to-day operations moving along as planned. It keeps inventory stocked, and employees and contractors paid. It keeps the lights on, the building heated and the water flowing. Cash outflows are a reflection of the above expenses, in addition to costs like interest and debt payments, among others.
Cash flow is also, generally speaking, an indication of a business’s success. If a business is not making money, and they expect to be doing so, there is usually cause for concern. Exceptions to this rule are companies that are purposefully running a deficit to finance rapid growth — a route taken by many tech startups.
When forecasting a business’s future earnings or assessing its overall health, accountants will typically compare cash flows month by month. Doing so gives the accountant an idea of whether a business is doing well (increasing cash inflows) or slowing down (decreasing cash inflows or increasing cash outflows). That said, an increasing cash inflow does not necessarily indicate that a business is doing well. It merely states that they are bringing in more cash, and it must be compared against its outflows.
What is profit?
Profit, or net income, is the amount of money a business has after they’ve accounted for all expenses. For example, if a restaurant’s revenue on a given day (generated by customers paying for food) equals $3,000 and their daily expenses (food costs, kitchen and wait staff salaries, rent, etc.) equals $2,000, the profit for that day is equal to $1,000.
Profit is typically the best indicator of a business’s success as it reflects its ability to actually generate value. No business can truly last long-term without generating a profit.
Note: Again, similar to tech startups neglecting cash inflows, many companies will run profit deficits for long periods of time while they’re working to grow and develop a sustainable business model. Running a profit deficit for an extended period of time is usually only possible with large amounts of equity financing.
What’s the difference – and why does it matter?
The difference between incoming cash flows and outgoing cash flows will usually be close to a business’s on-paper profit. But just because a business is profitable does not mean that it’s doing well. Indeed, a business can be profitable but have an incoming cash flow that’s too low to sustain that profitability.
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Example: Joe’s Ice Cream Stand
It’s the end of August in New York City and business is booming for Joe’s Ice Cream Stand. The Central Park staple had incoming cash flows of $40,000 in June, $50,000 in July and $60,000 in August. Outflows for each month were $20,000, $25,000 and $30,000 leading to profits of $20,000, $25,000 and $30,000 respectively.
Because of the business’s strong June, they had decided to add one more ice cream cart in July. Continued success added two more in August. And while the additional carts led to an increase in both cash inflows and total profit, the business’s overhead and outward cash flows shot up, too. The business also had to use nearly all of its cash in the bank to finance the added carts.
However, in October, cooling weather has reduced both consumer desire for ice cream and Joe’s incoming cash flows. In September, Joe’s three carts brought in a total of $40,000 in cash with the same $30,000 in expenses, leading to a total profit of $10,000. Near the end of October, Joe’s has just cleared $30,000 in revenue which means they’ll just clear profitability for the month.
Given that November in NYC is colder than October, it’s safe to assume that incoming cash flows will continue to decrease. And unless Joe’s significantly reduces its outgoing cash flows — e.g. close carts, fire excess help, order less inventory — the business will be forced to shut down.
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Profitability does not equal success
Seasonal operations like ice cream shops are common examples of businesses that struggle despite showing profitability. In this specific case, incoming cash flow is decreasing month-to-month while outgoing cash flow remains the same. Here, cash flow trumps profitability in terms of importance. Unless Joe’s has access to capital to maintain operations during the slow months, the business will most likely be forced to close.
The longevity of your business is ultimately dependent on your cash flow. It’s recommended that you perform a cash flow analysis at least once a month and begin to pay attention to trends to avoid being blindsided by any potential shortcomings. If you feel your business being crushed by upfront inventory costs, necessary equipment purchases or hiring more staff, you may want to consider a form of debt financing to fill the gap.