The Difference Between Cash Flow and Profit

Sales and profit are two very different things.

As a business owner, you can find yourself without the cash to pay bills, despite making sales you knew were profitable.

You may also be startled to discover that strong cash flows from sales deliver little profit.

So what is cash flow?

A cash flow forecast tracks cash flowing in and out of your business. The timing of these flows enables you to identify cash-rich and cash-lean periods. This helps in making the right decisions, such as when to buy assets or when to prepare for cash shortfalls.

The importance of cash flow

Cash flow is essential to the survival of your business—arguably more so than profit in the short term. Profit may be essential in the longer-term, but in the short-term, cash is needed to pay bills and operating costs.

For example, if you’re a home renovator with good cash reserves, you can survive until your business becomes profitable. However, if your business runs out of cash, you’ll need to find a solution quickly to avoid going bankrupt.

A definition of profit

Profit is usually defined as the money left in your business after all your expenses have been paid (although we use a profit equation that we believe serves you and your business better in the short and long term).

A profit and loss report (P&L), also referred to as an income statement, reveals what profit your business made last month or last quarter. 

Your profit is detailed in two figures:

  • Gross profit: what’s left from sales after deducting the costs of goods sold or services provided.
  • Net profit: what’s left from gross profit after operating costs (your business overheads) have been deducted.

Note that net profit still isn’t the final “bottom line” profit until all taxes have been paid.

The significance of profit

All businesses need profit to grow. Your profit can be allocated to several purposes, including:

  • Paying dividends to shareholders.
  • Reducing debt.
  • Buying more production assets.
  • Developing new products, new services, or intellectual property.
  • Marketing and business growth campaigns.

Why cash flow and profit can differ

The gap between a cash flow forecast and a P&L reflects the different ways business owners record financial data.

What does a cash flow forecast do?

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

  • Cash injections by the owner or investors.
  • Cash coming in from loans.
  • Cash from selling an asset.

These sources boost cash levels to fund your business, but none is profit.

Profit and loss reports show income and expenses

Unlike the cash flow forecast, the P&L includes accounting entries that don’t involve cash transactions but do affect the profit calculation, such as:

  • Depreciation expenses on fixed assets like equipment.
  • Bad debts.

Explaining discrepancies

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

  1. Where’s the money?

“The profit and loss report 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 money?”

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

  • The cash flow forecast shows the full $40,000 cash payment when it was made.
  • Profit and loss reports don’t show fixed assets–that’s what a balance sheet does. Your P&L will only show the depreciation amount (say, $4,000) as an expense, rather than the full $40,000 you spent on the asset. This makes the business’s net profit shown on the P&L seem much higher than the actual cash available in the bank.  
  1. 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’s a very clear distinction between the two. 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 P&L reveals the true picture.

The critical lesson here is to never 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.

  1. We’ve made many profitable sales, but we can’t pay our bills.

It’s 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. Businesses that sell on credit rather than cash terms are more at risk.

(Find out how a Profit First professional can help you avoid this risk and maximize your profit.) 

Actions that can lower cash flow

Reasons businesses can run out of cash include:

  • Excessive withdrawals by the owner(s).
  • Purchasing too much inventory relative to sales.
  • Taking on more loans than the business can service.
  • Buying assets at inappropriate times (such as during a slow period).
  • Prepayments or paying suppliers too soon. If suppliers offer 30 days, it makes sense to take advantage of the full credit period.

Cash flow is about timing

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 use up all your cash paying suppliers and other bills while waiting to collect amounts owed by customers.

Need help managing your cash flow? That’s our favourite thing to do, so tell us a little about your business and we’ll see what solutions are right for you.

In your corner,

The GuYDanS Team