Let’s dive into the battle of Cash Flow vs Profit. In business, there’s survival and there’s growth. To grow, you need profits. But to survive, you need cash.
They seem related—and they are. But they’re distinct entities, too. Having positive profit margins does not guarantee positive cash flow and therefore a successful business, and having a constant cash flow does not guarantee big profit margins.
So for a healthy business, one that can survive and thrive, you need both positive cash flow and profits—but you still need to know the difference between the two.
Cash Flow vs Profit: What is Profit?
Profit is basically the surplus that remains after all expenses are deducted from revenue. Of course, a successful business needs profit. You won’t be able to grow with a negative bottom line year after year.
There are three different types of profit that you should know about.
- Gross profit
Essentially, gross profit is income minus expenses. This includes all income your business earns, both from sales and from investments. From there, you deduct the cost of operating the business.
- Operating profit
In contrast, operating profit only includes the income you make directly from your main line of business, not including any income from outside investments.
- Net profit
Net profit is calculated by adding up total revenue and subtracting from it all expenses: these include the operating costs bus also the taxes.
Your goal should be to have a profitable business in the long run, since this is the only way a business not only survives but also grows. But that doesn’t mean that your business can’t exist without profits. As long as you have positive cash flow, your business can still survive in the short-term.
Cash Flow vs Profit: What is cash flow?
As its name indicates, cash flow refers to the inflow and outflow of money from a business. Cash flow is the money you have in hand to operate your business at any given time, and it’s an indicator of business liquidity. If you have positive cash flow, you can carry out your daily activities, pay off expenses and taxes, purchase equipment, inventory, and even handle emergencies with more confidence.
While you can bring in positive cash flow through sales, that’s not the only way to do it—cash can be acquired through loans from companies like Camino Financial, investment dividends, or by infusing your personal savings into the business.
Each of those options comes with its own risk and upside. But the crucial thing to remember is this: your business must be liquid for it to function. Cash is the oil that greases the machinery of operation. You need cash to pay the bills, pay the employees, pay for the inventory. Without cash, your business will grind to a halt.
It’s important to consider the many ways you can bring cash into your business and try to make the best use of them.
How can you be cash-poor and profitable at the same time?
The topic of cash flow vs profit presents an apparent contradiction: how can it be possible that your business might be profitable and have poor cash flow or have high cash flow with no profits? It’s important to go back to the definitions of profits and cash flow to understand the particular details that go into each one.
Have in mind that a sale is a multi-step transaction. It starts with an agreement between a vendor and a client to exchange goods and services for payment. That agreement has an effect on your bottom line, boosting your net profit. But just because a sale is agreed, it does not mean that your business immediately receives the cash from it; it’s only when you deliver a product or finish a project that you’ll receive your payment and your profit will increase. Have in mind that some customers may take more than 30 days to pay you and that’s the time it will take you to see any actual profit. Hence, the biggest difference between profit and cash is timing. Considering all the above, let see two opposite scenarios:
- If you’re you have long payment terms (in other words, your clients take a long time to pay you) but your accounts receivable are high (that is, you’re expecting a big check from your clients) your business can be profitable. At the end of the fiscal year, your profit margin formula will reveal that your business has a net profit. That doesn’t mean it is a successful business: you run the risk of lacking the cash flow needed on a daily basis to operate your business -pay your employees, buy materials or inventory, accept new projects, etc. In other words, your cash flow analysis will reveal that you don’t have available cash-in-hand. Without this cash flow, your business will soon fail.
- On the other hand, let’s say you get a business loan to have cash flow available and cover the capital needs of your business. This will allow your business to operate smoothly. However, your profits may be lower: have in mind that a portion of your revenue will be used to pay for your loan payments. If after a while you still make no profit, your business will eventually fail.
Cash flow vs Profit: What’s more important?
It’s an impossible question to answer without context—in the long run, you need both. But in short-term situations, one might be more critical than the other.
Especially in new businesses, cash flow is king. In the initial stages of your business, you have to expect a lot of expenses and investments: you need to be able to buy equipment, take advantage of new opportunities, hire new employees, and more. Without liquidity, your business won’t be able to act fast enough to keep up with or catch up to the competition. You can except your profit to be small in the short term, and that’s understandable. At the beginning of your business life, you have to focus on the proper running of your company and therefore on cash flow.
However, if your business is more established and on solid footing, then profit takes preference. Expenses are more stable, you can afford to let potentially risky investments pass you by, you have a better grasp of your inventory flows. With fewer surprises, you can plan ahead. You’ll have a better sense of how much cash you’ll need at different points throughout the year, liberating you to focus on increasing profits, which will lead to more long-term growth.
Sometimes, cash flow and profits are in contention with each other. It’s a very common cash flow vs profit scenario. Perhaps you’re torn between making a few smaller-scale sales that will bring in cash immediately versus making a bigger-scale sale that will take time before it’s paid off. If you need cash, then maybe you sacrifice the bigger profit. But conversely, if you don’t need as much cash on hand, then you can go after the bigger opportunities to bring in more revenue.
But of course, cash flow and profits are often in sync with each other, too. That’s an ideal scenario: there should always be a balance between both elements. Sales, after all, should eventually bring in cash while raising revenue. And your business needs cash to operate and pursue greater profits, and bigger profits will often bring in more cash.
To reach that situation, you need to understand the financial state of your business. And in order to do so, you need to know how to calculate both your profits and your cash flow.
How to calculate your cash flow and your profit: Accrual Accounting Vs Cash Accounting
There are two different types of accounting methods that you should be aware of—and be put into practice. The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts.
- Accrual accounting recognizes and tracks revenue when a sale is agreed, and expenses when they are billed (not yet paid in cash or in full). In other words, the moment you make a sale or the moment you agree to buy a new piece of equipment, those transactions are tracked and the appropriate accounting columns are modified. This accrual basis gives you an accurate idea of your company’s profit in terms of its income and expenses during a period of time. It is a great method to track your profits and it provides you with a long-term picture of your company that cash accounting can’t provide. But the downside is that this system is not a good indicator of your cash flow.
- Cash accounting, on the other hand, recognizes revenue and expenses only when money changes hands. A sale doesn’t get recorded until you receive payment and you have the money in hand; that expensive new piece of equipment is reflected in your balance the moment you pay for it. Many small businesses opt for the cash accounting system because it’s simple to handle. It’s easy to determine when a transaction has occurred and there is no need to track receivables or payables. This is a good way to track how much cash the business actually has at any given time, but it’s unable to provide you with a long-term picture of your business profitability.
When it comes to cash flow vs profit, at the end of the day, your business needs a balance of both cash flow and positive profit margins. To be in control of both aspects, you or your accountant should use both the accrual and the cash accounting systems. To thrive in the long-term, you need to survive in the short-term. It’s vital that you monitor long-term growth while you’re also tracking your short-term health and viability. Cash flow and profit are distinct but interrelated. It’s important you know where they diverge and how they interconnect.
If you feel your business suffers from the lack of cash flow to run your daily operations, please consider applying for a business loan with Camino Financial. Many of our members use our business loans for that purpose. Not only will that loan provide you with the cash you need to handle your short-term expenses, but that immediate flexibility can help you pursue long-term growth and profits. Start the application process today: one you know you are pre-approved, you could receive your funds within 4-10 days, so your business doesn’t run short on cash for another day.