Cash flow and profitability are both important metrics used in business finance and especially in the world of accounting. They serve as great tools for measuring success and financial health and your accountant has probably talked about these before. If you’re confused, you’re not alone!
A lot of business owners often confuse the difference between profit and cash flow and it can be a struggle to understand the difference. They’re both important factors to consider when making financial decisions about your business and figuring out if your business is actually profitable or not—but most business owners get these confused.
For entrepreneurs and business owners, understanding the relationship between cash flow vs profit can help you make better business decisions and impact your overall stability. Because let’s face it -- we all want profitable, financially stable businesses.
What Is Cash Flow?
Some people assume that positive cash flow means profit but this is a common misconception.
In simple terms, cash flow is money going in and out of your business at any given time. In other words, it's money that constantly flows in and out of your business via invoices, sales, expenses, operating activities, taxes, employees, investing, etc.
There can be both positive and negative cash flow in your business. Positive cash flow is where most business owners get confused about profitability.
Positive cash flow is an indicator that a company or business has more cash coming into the business than it does going out of the business. Positive cash flow indicates that a business's available financial resources are increasing but it is not the money that ends up in your pocket .
Can you have positive cash flow and not make profits? Absolutely. If you take out a business loan, you can easily have positive cash flow but not make enough money to pay yourself as a business owner because it’s going out the door over the course of a period of time to finance your expenses and growth.
On the other hand, negative cash flow occurs when there is more money going out of the business rather than coming in. Your business can still be profitable with a negative cash flow, like when you have to pay bills before an invoice is paid by a client.
What’s important to remember is that positive cash flow can help you build up a financial buffer in your business in case a financial crisis arises and can allow you to build up savings in a emergency funds account or be able to make larger financial investments in your company’s growth—but it’s not an indicator of if your company is profitable.
What Is Profit?
Profit is also known as your net income, or the surplus after all expenses are deducted from revenue. It’s what you probably think of when you think of your company’s financial performance.
Profit can be broken up into three different types: gross profit, operating profit, and net profit. Each metric is used to determine the business’ overall performance and can help you compare how your business is growing.
Gross profit is your profits after subtracting the costs to make what you’re selling, without other expenses. If you sell a product for $25 and the supplies to make it cost $5, your gross profit is $20 per product sold. Most service based businesses don’t have costs of production associated with their services so gross profit is often just what is invoiced to clients. Gross profit is a good number to know but doesn’t tell you how profitable your company actually is.
Operating profit is your gross profit minus operating expenses. For instance, if you’re a consultant and don’t have a cost for producing your services, you would subtract operating costs from your gross profit. Say you invoiced clients $5,000 last month and spent $500 on the tools you use to do your work. Your operating profit would be $4,500. Things that fall into operating expenses generally don’t increase as you increase production, like tools, rent, internet costs. Operating profit tells you how well your business is running but still doesn’t tell you how much money you’re making.
Net profit is the most important profit number to know because it tells you if you’re making money in your business. To get your net profit, you subtract one-time expenses or non-operational expenses from your operating profit. This can include things like taxes, loans, investments in new equipment, legal fees, or even one-time sales of business assets. Your net profit tells you the final picture of if you’ve made money or not. For instance, if you have a $1,000 business loan payment after generating $4,500 of operating profit, your net profit would end up being $3,500.
Generally speaking, profitability is determined on a longer period of time than cash flow and looks at the total picture of your finances at the highest, least detailed level. Profitability is usually calculated on a quarterly or annual basis but cash flow is usually calculated on a monthly basis or even daily basis.
How Does Cash Flow Differ From Profit?
Still confused about whether cash flow equals profit? The answer is: not usually. Although they sound similar, positive cash flow and profit are different from each other.
Cash flow includes a complete picture of where money is going in your business. Profit is the actual money you’re making. The key difference between the two is that cash flow is referring to the money going both in and out of the business while profit is the amount of money left over after all of your expenses are paid.
If you run your business on an accrual basis, cash flow vs profit is easier to understand because invoices are counted when they are billed but the money won’t be in your account until your invoice is actually paid. This can make your business profitable but make your cash flow more difficult.
For example, if you’re an online coach and invoice a client $5,000 this month and spend $1,000 in expenses, your profit is $4,000. But because that invoice will actually be paid next month and you haven’t received any money from your client yet, your cash flow is -$1,000. You’re profitable this month but your cash flow is negative.
On the other hand, the next month you have $1,000 of expenses again but no new invoices. Your client pays the last month’s invoice for $5,000. Your profitability is -$1,000 this month because the invoice was counted in the previous month but your cash flow is positive.
Why does this matter? If that $1,000 expense is for tools you need to do your job, and if you don’t have money to cover the negative cash flow in the first month, you won’t be able to cover your expenses and do your work. While your business is still profitable, you’re going to run into financial trouble if you don’t care about cash flow!
Which Is More Important: Cash Flow or Profit?
It’s not uncommon to want a single metric to help you understand the health of your business -- let’s face it, that would be much easier! Business owners want to know which one they should look to for answers or pay attention to the most to determine the growth of their business. That is why cash flow positive vs profitable is often pitted against one another.
When it comes to figuring out which metric matters more in business, many owners assume that cash flow is more important than profit or vice versa. Both have the power to influence your business decisions and should play a part in your financial decisions.
You need both cash flow and profit in order to effectively run and scale your business. Doing cash flow projections to figure out when you need funds to pay bills and when money will be coming in can help you better manage your money for less stress. Paying attention to your profitability can help you make a financially successful business.
Cash flow and profitability work together to make a business that succeeds with less stress! And who doesn’t want that for their business?
Want to learn more about your business finances and finally understand what’s going on with your money? Start with a financial action plan to get your small business finances in order.