Profit and Cash Flow – Understanding the Difference


Profit and Cash Flow – Understanding the Difference

Profit and cash flow are both crucial aspects of a business. Understanding how the two areas differ and work together is important for any business owner, but what exactly is the difference?
In short, cash flow is the inflow and outflow of actual money within your business and it mimics your bank statement. You need it for daily use, such as inventory purchases, daily operations and paying employees.
Profit is the surplus after the expenses have been deducted from your revenue and it does NOT mimic your bank statement. Earning revenue does not necessarily mean that you will have cash flow available immediately, especially if you are a new business and especially if your customers pay you at month end or thirty days later.
Let’s look at it this way, a business can be profitable and still not have enough cash flow to survive. For example, if you are selling reporting software for business analysis, you can be making a profit on each product you sell. However, if your service goes through a lengthy sales process and it takes a few months for your corporate customers to pay their first invoice, you may show a large profit but because your customer has not paid, you could go bankrupt before you even got properly started.
You therefore typically need cash flow to get the project started and even though your unit sales are profitable, you will probably need some sort of funding to pay your suppliers up-front, meet payroll and pay other operations expenses within your business.
In this case, cash flow is the most important thing keeping the company running, but this is not always the case and often depends on the business and the circumstances. The absence of profit will eventually have a declining effect on your cash flow, as there will be no more profit to feed into the cash flow bucket.

Rapid growth and business failure

Increased sales can cause major cash flow problems in your business. An increase in sales is really important for your business, but if you do not have enough cash in time to pay for the stock you are selling, or pay the new staff you need at the end of the month, you may find yourselves in a sticky situation.
Here are some factors to consider that can affect cash flow and profit in your business:

Customer service risks

If you are increasing sales in the business to a point where your service team cannot keep up, you risk creating customer service problems and unsatisfactory customer service, which normally leads to loss of clients in the long run. In this case, short term cash shortages lead to long declines in profit.

Operational risks

Rapid growth increases the need for additional or different operations requirements in your business. If your business has grown too fast without proper cashflow planning, you risk going bankrupt very quickly.

Over-optimistic spending

The success of sales in business can often lead to the company making large spending decisions, such as hiring new staff, buying new equipment or improving the office space. Focussing on spending what you have and not what you expect will radically work in your favour.

Avoiding the pitfalls

So, how do you manage cash flow so that your business does not fail? Cash vs profit is one of the most difficult concepts for business owners with no accounting training to understand.
Some Part Time FD tips:

  • Qualified accountants should be used BEFORE you start your company, just to make sure your business model has the appropriate cashflow planning in place
  • Significant growth and capital expenditure plans should be discussed with your accountant, beforehand if possible, but sooner rather than later
  • Ask your accountant to explain how cashflow vs profit works and learn to understand the concept. It could be the best piece of education of your life.
  • For start-ups, make sure your accountant can explain to you how much cash you need to fund the business from start-up to receiving money from your customers. This period is often longer than you first thought.
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