Accounting

What is the difference between profit and cash flow?

7 min read

As a growing business, making more money is your primary end goal. An equally important goal, however, involves optimally managing the money that you do make. Profit and cash flow are often conflated, but they are unique concepts that must be understood and planned for in their own right. Here, we break this down in detail:

What is a profit?

Profit, or net income, is simply your revenue minus your expenses. In case this net income is negative, it is called a loss. There are two ways to define profit:
 
  • Gross profit is the profit made after deducting costs directly related to the provision of goods and services.
  • Net profit is the profit made after further deducting other expenses like payroll, rent and tax.
 
Profit, often seen as the primary marker of business success, provides a useful measure of how effectively a company turns revenues into earnings. However, profits do not necessarily equate to immediate cash in the bank. For example, a business can make sales (which count towards profit), but if those are credit sales, the actual cash may not come in until a later date.
 
Moreover, profit is crucial in the long-term strategy of a business. If a company consistently generates profit, it indicates its business model is effective and creates value from its operations. High profit provides opportunities to invest in expansion, reward shareholders, and build a buffer against future financial challenges.

What is cash flow?

On the other hand, cash flow refers to the money coming in and going out of the business at any time. If more money comes in overall, you have a positive cash flow. If more money goes out overall, you have a negative cash flow.
 
The cash flow is detailed in the cash flow statement, reconciling the opening and closing cash amounts for a specified period and delineating where the cash came and went during that time. The change in the overall cash amount from one accounting period to the next is known as net change in cash.
 
Cash flow provides a more immediate snapshot of your financial health. It is the lifeblood of a business and a critical factor in its ongoing viability. A company might have a very profitable business model but may need to manage its cash flow correctly to stay afloat.
 
From these definitions, we can summarise the core difference between profit and cash flow as: 
Profit measures the amount of money left over after all business expenses have been paid, while cash flow measures the net movement of cash into and out of the business.

Examples of profit and cash flow differences

Consider a retail business that sells furniture. In January, they sold 100 units of a certain product for £500 each, totalling £50,000 in revenue. Their cost to manufacture each unit is £300, so the gross profit is £200 per unit or £20,000 total. After accounting for operating expenses such as salaries, rent, utilities, etc, the net profit is around £10,000. This is a simplified example, but it explains how profit is calculated.
 
Now, let us consider cash flow. The same business sold the furniture on net-30 terms, meaning customers have 30 days to pay their invoices. So, while the company has made sales (and profit) in January, they may not receive the cash from these sales until February.
 
In the meantime, they must pay their manufacturers, employees, utilities, and rent. If the company did not have enough cash reserves or other cash inflows, it could face cash flow problems despite being profitable.

Which is more important, profit or cash flow?

As you can probably guess, there is no competition here. Both profit and cash flow are core metrics to gauge how healthy your business is. While profit measures how sustainable the company is on a continued basis, cash flow measures its ability to pay its bills. 
 
Moreover, profit and cash flow move independently of each other. For instance, your business could be making a profit but running a negative cash flow, perhaps owing to too much cash being tied up in receivables or inventory. That affects your ability to pay your expenses and meet immediate cash needs, which could disrupt the day-to-day flow of business operations.
 
Conversely, you could have a positive cash flow thanks to steady sales but still be making losses, which will affect you staying afloat unless you break even.
Strategies for managing profit and cash flow
  • Delayed invoicing often leads to delayed payments. To maintain a positive cash flow, invoice your customers immediately. Regular follow-ups on pending payments can also ensure timely collection.
  • Consider discussing longer payment terms with suppliers to align your cash outflows with inflows. This may allow you to pay your suppliers after you’ve received payment from your customers.
  • You could offer a small discount to encourage customers to pay their invoices early. This can incentivize early payments and improve your cash flow.
  • Just like personal finances, businesses should also maintain an emergency fund. This cash reserve can help meet unexpected expenses or bridge the gap during periods of negative cash flow.
  • Create multiple streams of income. This can help ensure the business relies on more than one product or service for its revenue, thereby increasing profitability and providing a steadier cash flow.

Managing profit and cash flow is not a one-time task but requires regular monitoring and adjustment. It is also essential to understand that the following strategies will vary based on business type, industry, size, and lifecycle stage. Seek advice from Golding Accountancy for a strategy tailored to your business circumstances.

Over to you

Both profit and cash flow need to be planned for with care so that you are never too far in the red with either of them. We can help you develop suitable strategies and process changes, such as staggering expenses or increasing the percentage of your invoices you demand upfront. 
 
Remember – you need to turn a profit to stay solvent, but you also need enough ready cash to meet your obligations! Get in touch with us to have a plan for both of them, and you will be set for healthy growth.

FAQs

Both profit and cash flow measure aspects of a company’s financial health. Cash flow helps the company make smart financial choices based on whether or not it has the funds to meet immediate expenses. On the other hand, profit indicates trends in sales. It thus allows the company to align its objectives with its actual performance, such as if there are seasonal fluctuations to be accounted for.

It might seem counterintuitive, but high growth could negatively affect your cash flow. For example, when business is good, you might take on more orders than you have the cash to fulfil. At that point, you must rustle up cash by taking a loan or selling stock, which is not ideal. Therefore, it is vital not to lose sight of short-term practicalities in pursuing long-term growth.

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