Introduction
Have you ever looked at your financials and noticed that your bank balance differs from your month’s profits? Did this leave you confused, unsure if your business was doing well or not?
If yes, then this guide is for you. By the end of this guide, you will understand the difference between cash flow and profit and what it means for you as an entrepreneur or small business owner. You’ll also learn how this knowledge can help you grow your business sustainably and quickly.
Meet the Author – Shishir Khadka
Hi, I’m Shishir Khadka. I’m a Chartered Certified Accountant with over 20 years of experience turned cash flow specialist for ambitious, growth-minded small business owners based in the UK. I’ve helped my clients reach £53.8m in annual revenues.
If you want to scale your business fast from five figures to six figures or from six to seven figures, understanding the differences between cash flow and profit is crucial. With this newfound knowledge, you can improve both cash flow and profitability.
Let’s dive in!
3 Key Takeaways
- Cash flow and profit are two sides of the same coin: Profit shows financial gain, while cash flow tracks actual money movement.
- Cash flow is king: Even profitable businesses can struggle if they lack cash to cover immediate expenses.
- Balance is key: Understanding both cash flow and profit allows businesses to make informed decisions, maintain liquidity, and plan for growth.
What is Cash Flow?
Cash flow is the net movement of cash inflows and outflows of a business within a specific time frame. It is a crucial component of accounting and finance, affecting liquidity, financial solvency, and critical financial decision-making.
The Importance of Cash Flow in Business Operations : Fuel for a Car Analogy
Think of cash flow like fuel for a car: without fuel, a car comes to a standstill. Similarly, without cash flow, business operations come to a halt. Just like a car needs fuel to run, a business needs cash flow to operate effectively and meet its daily obligations.
What is Profit?
Profit, often referred to as the bottom line or net income, is detailed in the income statement. It represents the financial gain or loss remaining after all costs required to fulfill obligations and run the business are deducted from total revenue. Profit is a key metric that indicates a company’s financial health and success over a specific period.
Profit Analogy: The Engine of a Car – The Role of Profit in Business Success
Profit is a crucial indicator of a business’s financial health, focusing on its performance, long-term solvency, growth, and potential for future opportunities. Profit can be compared to the engine of a car, driving all operations within the business. If the engine fails, the car comes to a standstill. Similarly, if a business is not generating profit, it cannot sustain itself in the long run and will eventually face failure.
Just like driving requires both a functioning engine and adequate fuel, running a business requires both profit and cash flow. While profit (the engine) keeps generating cash, cash flow (the fuel) ensures the business can operate smoothly day-to-day. To drive safely without encountering problems, you need a well-maintained car. Similarly, maintaining good financial health requires both strong cash flow and consistent profit, which are key components of a business’s financial statements.
What is the Difference Between Cash Flow and Profit?
Cash flow and profit are often considered two sides of the same coin. It mainly refers to when:
Money is Incurred vs. When Money is Paid
- Profit is calculated after costs, expenses, and tax payables are incurred from revenue.
- Cash flow is determined after these costs, expenses, and taxes are actually paid using cash receipts from revenue.
For example, operating cash flow focuses on cash transactions, showing the real cash available from core business operations. In contrast, net income reflects profit, including non-cash items such as depreciation expense, and may include revenue not yet received in cash.
Theoretical Earnings vs. Real-Time Cash Position
The key difference lies in the timing of when money is incurred versus when it is paid. While profit indicates the theoretical earnings, cash flow shows the real-time cash position, which is essential for daily operations.
Score vs. Stamina Analogy
Cash Flow as Stamina
Think of business as both a marathon and an intellectual sport.
- Cash Flow (Stamina): To stay in business for the long haul, you need stamina, which is provided by cash flow. Cash flow represents the actual cash available to keep the business running day-to-day.
Profit as Score
- Profit (Score): At the same time, you need to improve your score in the business game, which is achieved by generating profit. Profit measures your success and effectiveness in using resources to create value.
Why are Cash Flow and Profit Different?
- Timing of Cash Transactions vs. Accrual Accounting: Cash flow and profit differ primarily due to the timing of cash transactions versus accrual accounting. Profit accounts for income and expenses when they are incurred, not necessarily when cash changes hands.
- Examples of Cash Flow Challenges Despite Profit: Cash flow tracks the actual inflow and outflow of cash. This difference means that a business can show a profit on paper while still facing cash flow challenges due to delayed payments or high levels of inventory.
How are Cash Flow and Profit Related?
- Long-Term Success and Daily Operations: Cash flow and profit are related because profit can lead to cash flow over time, but they do not always align immediately.
- How Positive Profit Can Lead to Improved Cash Flow: Profit is a long-term indicator of business success, while cash flow shows immediate financial health. Positive profit can eventually improve cash flow, but effective cash flow management ensures that the business can operate daily without interruption.
- The Need for Effective Cash Flow Management: Both are necessary for the financial stability and growth of a business. Imagine needing to hire more staff. You need cash, not just profit, to pay them. Profit is like having the skill to play the game, but cash flow is the stamina to keep playing.
Table: Differentiating Cash Flow vs Profit
| Aspect | Cash Flow | Profit |
|---|---|---|
|
Definition |
Net movement of cash into and out of a business |
Financial gain or loss after all expenses are deducted from total revenue |
|
Measurement |
Based on actual cash transactions (Cash Flow Statement) |
Based on accrual accounting, recognizing revenue and expenses when they are incurred (Income Statement) |
|
Purpose |
Ensures liquidity for short-term obligations |
Measures overall financial performance over a specific period (Financial Statements) |
|
Key Components |
Operating, investing, and financing cash flow |
Gross profit, operating profit, and net profit |
|
Focus |
Short-term cash availability |
Long-term profitability and financial performance |
|
Timing |
Real-time cash position |
Accrual-based, over a period (e.g., quarterly, annually) |
|
Impact of Credit |
Immediate effect when cash is received or paid |
May not affect profit immediately if sales are on credit |
|
Importance |
Crucial for daily operations (e.g., paying HMRC, suppliers) |
Essential for assessing sustainability, investment, and growth |
|
Examples |
Cash from sales, paying suppliers, VAT payments |
Total revenue minus costs (e.g., selling goods at £100,000 with £70,000 in costs results in £30,000 profit) |
|
Risk |
Negative cash flow can lead to liquidity issues |
Lack of profit over time can lead to business failure |
Practical Example: Profit Without Cash Flow
Meet Heather – Mega Profit Limited Case Study
Meet Heather, who runs Mega Profit Limited in London, UK, selling luxury handbags.
Profit and Loss Statement Overview
In 2023, Mega Profit Limited did £500,000 in sales, generating a net profit of £100,000 and a cash balance of £80,000.
Cash Flow Statement Overview
Comparison of Cash Flow and Profit in Heather’s Business
On 1 February 2024, Heather reviews her financials:
- Cash Flow: In January, although sales were £250k, only £187.5k was collected in cash. The cash outflow was £100k, leaving a closing balance of £167.5k. This included paying for previous months’ costs and expenses.
- Profit: January’s sales recorded were £250k with costs of £125k and fixed expenses of £50k, resulting in a profit of £75k.
Even though Heather’s business shows a profit, the cash flow provides a different picture of available cash.
- Adjusting for Changes in Working Capital: For Heather’s case, this would involve adding back non-cash expenses and adjusting for changes in accounts payable, receivable, and inventory to get a clearer picture of her actual cash flow.
Why Understanding the Difference Between Cash Flow and Profit Matters from a Cash Flow Perspective
- Liquidity Management: Understanding cash flow helps businesses maintain the liquidity necessary to meet immediate obligations.
- Avoiding Insolvency: Monitoring cash flow can help prevent situations where a business cannot pay its bills, despite being profitable.
- Informed Decision-Making: Cash flow insights enable better decision-making, especially regarding capital expenditures, hiring, and expansion.
- Investment Planning: A strong understanding of cash flow vs. profit allows businesses to plan for investments in growth without straining their cash reserves.
- Maintaining Supplier and Customer Relationships: By managing cash flow effectively, businesses can pay suppliers on time and maintain a steady flow of goods.
Master Cash Flow vs Profit With A Video Walkthrough
If you prefer to watch a video demonstrating the difference between the two and how it impacts your business, watch this
Your Next Step after learning about cash flow vs profit
As we have covered, the difference between cash flow and profit, now you have two options.
Option 1: Keep Learning
I advise you to understand two cash flow sub topics. Cash Flow statement and cash flow analysis, which are highly related to difference between profit vs cash flow.
Mastering your cash flow statement is the key to unlocking a clearer understanding of your business’s financial health.
- Start by exploring my article on “Understanding Your Cash Flow Statement” to learn how to read and interpret this crucial financial document.
- Then, take your knowledge further with “Cash Flow Analysis: Uncover Hidden Opportunities and Risks]”. This guide will help you identify trends, pinpoint areas for improvement, and proactively manage your cash flow for sustainable growth.
Option 2: Book a Free Call
Are you tired of the cash flow vs. profit dilemma holding your business back?
Let’s talk.
Book a free 30-minute cash flow strategy session with me.
We’ll delve into your unique situation, uncover hidden cash flow opportunities, and create a plan to ensure your business has the financial fuel it needs to thrive.
Click here to schedule your call today.
