Cash Flow v. Profit: How You Can Have One, but Not the Other

March 9, 2020 | Article

As your small business grows, you may notice that you’re becoming more profitable. However, you also seem to be running out of cash.

This is a common occurrence in business growth. Often, profitability is confused with cash flow in the business world. Cash flow is not profit and these two measurements each tell you something different about your business.

The Difference Between Cash Flow & Profit
Cash flow and profit are two different things. Cash is the difference between the cash you have at the beginning of the period and the end of the period.

Profitability, on the other hand, is what’s left over after deducting business expenses from the income you generate.

How You Calculate Profitability
The first step to understanding cash flow v. profit in your small business is to look at some basic terminology.

A balance sheet is the measurement of a company’s resources, including cash. Typically, a balance sheet has three components: assets, liabilities and equity.

  • Assets are the stuff you own or stuff that is owed to you. This includes cash, receivables, inventory, property and equipment.
  • Liabilities are the things you owe. This includes accounts payable, credit cards payable, gift cards outstanding, notes payable, sales tax and payroll taxes.
  • Equity is the worth of your business. Equity is comprised of common stock, paid in capital, contributions/distributions and retained earnings.

Profit & Loss is how your business measures its profitability. This is done through sales, costs of goods, operating expenses and other income/expenses.

  • Sales are the gross proceeds received from the sale of a product or service.
  • Cost of Goods are the costs incurred directly related to the sales generated. These vary based on the level of sales.
  • Operating Expenses are the normal, ongoing costs incurred to conduct your business. This includes office wages, professional fees, supplies, bank fees, etc.
  • Other income/expenses are the sources of income earned and expenses incurred outside of normal business.

You get to profitability by deducting your expenses from your income.

SALES – COSTS OF GOODS SOLD – OPERATING EXPENSES ± OTHER INCOME/EXPENSES = NET INCOME (PROFITABILITY)

How to Calculate Cash Flow
At its simplest form, cash flow equals the cash changes in assets, liabilities and equity. Cash flow is provided or used by various activities of the business. The activities are broken into three categories: operating, investing, and financing.

  • Operating activities start with net income and adjust for non-cash transactions. These adjustments include, but are not limited to, depreciation, gains and losses on sales property and equipment, and bad debt expense. Once adjusted for the non-cash transactions, net income is adjusted for the changes in operating assets and liabilities. This includes accounts receivable, inventory, prepaids, accounts payable, and accrued liabilities are added or deducted.
  • Investing activities include, but are not limited to, cash payments to purchase investments, property or equipment or fixed assets. Or on the other hand, cash received from selling an investment (or receiving a dividend from an investment), property or equipment.
  • Financing activities involve cash payments on long-term debt, cash received from issuance of long-term debt, net change (cash received and paid) on a line of credit, and cash contributions or distributions from owner.

All of this goes into the cash flow of your small business.

Examples of Cash Flow V. Profitability
Here are a few ways cash flow can differ from profitability in your business.

  • If you have a lot of work and have sold a lot of your product or service, you may be really profitable. But, if your customers aren’t paying you in a timely manner, you may not have a lot of cash.
  • If you took out a loan to start or expand a business, but you’ve been selling your services for less than they cost, you may still have some cash, but you aren’t profitable.
  • If you’ve invested in a lot of inventory recently and are still holding on to it. While this doesn’t affect your company’s profitability (until the inventory is sold), it’s certainly a drain on your cash.
  • If you are holding off on paying off debts, the timing of the payments can increase your cash flow, but it won’t help your profitability.

Why Understanding Cash Flow v. Profit Matters
Each of these terms and their corresponding metrics tells you something about your business. But they’re not the same and it’s important not to confuse them. You can have profitability without adequate cash flow. You can also have a steady cash flow and not be profitable.

Understanding the difference helps you know what’s happening in your business and can show you ways to solve problems you may be facing.

Still unsure? Utilize a trusted advisor to help outsource some of these functions of your business. Here are a few reasons to consider outsourcing.

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