Cash Flow vs Profit – Part 1
Cash Flow vs Profit
It’s a well-known phrase, but it’s worth repeating:
- Turnover is vanity
- Net profit is sanity
- Cash flow is reality
The fact is: in any business, cash is king!
If you have plenty of cash in the bank to run the day-to-day operations of your business, you’ll probably feel quite comfortable about the future of your business.
On the other hand, if there is a lack of cash in the business and you are struggling to pay the bills, then you’re more likely to be having sleepless nights.
It’s vital that you control the cash flow in your business, but it’s also important to understand what cash flow is and how it differs from profit. I come across business owners on a regular basis who run a profitable business, but they don’t have any cash in the bank and can’t understand why.
So, over the next couple of weeks, I’m going to examine the difference between cash flow and profit and also look at what steps business owners can take towards building up a positive cash flow.
What’s the difference between Profit and Cash Flow?
The profitability of a business is measured by looking at income and expenses. Put simply, if your income exceeds your expenses your profitable. On the other hand if your expenses exceed your income then you’re making a loss.
Cash flow refers to the total amount of money that’s flowing into and out of the business. Being cash flow positive simply means your business has more money coming into the business than it does going out.
The question I am often asked is: “I don’t understand. If I’m profitable why don’t I have any cash in the business, what’s going wrong?”
Although being cash flow positive and being profitable aren’t the same, they are interconnected. And in fact, you can be cash flow positive but not profitable, and you can be profitable but not cash flow positive.
Let me explain the difference using this example:
- Your total income last year was £300,000. Your total expenses, including cost of sales, payroll and all other expenses came to £250,000. That means your business was profitable and achieved a £50,000 profit.
- But most businesses when they do their accounts at the end of the year, use a method of accounting called accrual accounting. This is simply a way of recording all income and expenses that are incurred rather than received or paid. Unfortunately, at the year-end a client who you have done work for still owes you £60,000 on an unpaid invoice.
- That means, although the good news is you made a profit for the year of £50,000, the cash flow looks very different.
- Let’s look at the cash flow. Bear in mind your expenses for the year were £250,000. The income was £300,000, but remember you have an outstanding invoice of £60,000 which means that in cash terms you actually only received £240,000 (i.e. £300,000 less £60,000) and because your expenses were £250,000 it means your cash flow is in negative territory to the tune of £10,000.
- In this example, at the end of your financial year you had made a profit of £50,000 – great! But your cash flow is £10,000 short – not so great!
So, what are the implications for your business?
Put simply, you should have a daily focus on cash flow
Profitability gives a great general overview of the finances of your business. Profit is also important because if you’re achieving profit each month, then you know that your business model is working and that’s important for a business going forward.
But in terms of the day-to-day survival of the business, profitability can be misleading. As you will have seen from the example above, net profit doesn’t factor in whether actual cash is coming into the business.
Cash flow on the other hand, tracks money in and money out in real time.
Whilst, positive cash flow means you have money available to run your business, negative cash flow will shut your business down faster than anything else; as you won’t have the funds available to capture growth opportunities, to pay for marketing as well as the other operating expenses.
You absolutely must ensure your business is cash flow positive at all times. Easier said than done so next week I’ll look at ways to help you monitor and improve your cash flow.