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The Difference Between Cash Flow and Profit

Profit and cash flow are different concepts with different results. Profit looks at your income and expenses at a certain point in time, usually at the end of the financial year. Cash flow is more dynamic, looking at the timing of the movement of money in and out of your business every day.

The difference between profit and cash flow

Cash flow is the difference between the available cash at the beginning of an accounting period and the end of the period. Cash comes in from sales, loan proceeds, investments and the sale of assets and goes out to pay for operating and direct expenses, principal debt service, and the purchase of assets. Profit is the money you have left over after your business' expenses are paid. Creating a cashflow forecast by mapping out when cash comes in, and when it has to be paid out, your business can identify when it will need cash on hand.

If you run your business on a cash basis, you probably have a good idea of your cash flows. But you might not know if your business is actually generating a profit, and if so, how much before it is too late.

Conversely, if you focus on profits it's possible to be making a profit every month, but you could be running out of cash.

Here is why.

Why cash flow and profit can differ

The gap between a cash flow forecast and a profit statement reflects the different ways business owners record financial data.

Cash flow

A cash flow forecast only records actual cash transactions. Cash flow can be boosted by inputs other than sales:

  • Capital injection by the owner or investors.
  • Cash from selling an asset.

These sources boost cash levels to the business, but are not 'profit' as they are not generated by the normal operation of the business. You could have cash in the bank but could be in a loss position.

It's the same with cash going out. If you buy expensive equipment, or large amounts of inventory (and never sell it), you could be making a profit but be running out of cash (as you keep spending it).

Profit and loss

Unlike the cash flow forecast, the income or profit statement includes inputs that don't involve cash outlays but do affect the profit calculation, such as:

  • Depreciation expenses on capital assets such as equipment
  • Debts written down, such as writing off an uncollectible account receivable owed by a customer
  • Assets sold at a loss or profit
  • A build up of inventory that remains unsold

Discrepancy examples

These scenarios help explain the gap between cash flow and profit.

"Where's the money?"

"The income statement shows a $50,000 profit, but the cash in the bank is only a fraction of this. The figures don't match up. Where's the missing profit?"

A common example that can raise this question is a business that buys equipment (a "fixed" asset or "capital" asset) for $40,000.

  • The cash flow forecast shows the full $40,000 cash payment going out when the asset was purchased
  • On the income statement, the business will claim only the depreciation amount on a capital asset as an expense. If the depreciation rate was 10%, then only $4,000 is an expense against sales. This makes the business' net profit seem much higher than the actual cash available in the bank
"Sales are great, so we must be profitable"

"We've been extremely busy these past few months. Sales are booming but I can't see any profit."

Inexperienced business owners can easily confuse 'being busy' with being profitable, but there is a very clear distinction. Your profit is always what's left after all costs have been deducted.

If you haven't calculated your selling prices correctly, your 'thriving' business may in fact be operating at a loss. The cash flow may seem great, but the profit and loss account reveals the true picture.

The critical lesson here is never to set your prices until you know all the costs involved. You might end up operating at a loss or at an unsustainably small profit level.

"We've made many profitable sales, but can't pay our bills"

It is quite possible to run out of cash or go bankrupt by taking on too much business too quickly, even though each sale is profitable. This is called overtrading and businesses that sell on credit rather than cash terms are more at risk.

Cash flow is all about the timing of money inflows and outflows. If you expend significant cash to pay operating expenses and miscalculate the actual time to collect customer receivables, or your business is poor at collecting on overdue accounts, you can easily deplete all of your cash paying suppliers and other bills while waiting to collect amounts owed by customers.

Lack of timeliness

If you finish a job in January but don't get paid until May, your records look like you generated the revenue in May, not January. Thus, it's hard to associate revenues with the work you did and when you did it. In this case, it might look like you were operating at a loss between January and May, but you actually had a profit that wasn't yet booked.

Accrual method of accounting

The accrual method recognizes revenue when it's earned and expenses when they're incurred. You might be recording transactions at the time they occur but not receiving or making payments until weeks later.

Accrual accounting follows generally accepted accounting principles, including the matching principle.

You encounter situations in accrual accounting not present in cash accounting, such as:

  • Paying for expenses like insurance before they're due
  • Receiving payments in advance of earning them, such as when selling magazine subscriptions for 12 months in advance
  • Paying for expenses after incurring them, usually through accounts payable, wages payable or taxes payable
  • Booking earnings before getting paid, normally via accounts receivable
  • Writing off the cost of equipment and other long-term assets as you use them rather than all at once

Under accrual accounting, you track all of these events to know your profit and loss for the period and report them on your income statement. But you have to take extra steps to manage your cash flows because they're not directly evident from your income statement.

Next steps

  • Use the Cash Flow template to understand your business' cash flow better
  • Contact us to learn about solutions available to improve your cash flow
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