Understanding the Difference Between Cash Flow and Profit

Cash flow and profit both are important financial metrics of a healthy, growing business. Many small business owners and new entrepreneurs are often in confusion between these two terms. However, cash flow and profit are not the same things and it’s important to know the difference between them.

As a small business owner, understanding the difference between making and managing money is critical to achieving long term success. While most businesses focus on making profits without realizing that it’s the cash flow what helps them keep their businesses afloat during tough times. 

Keep reading while we’re going to break down the key difference between cash flow and profit so you can better manage your finance, understand your cash position, and meet your business goals. 

What is a Profit?

Also called net income, profit is the amount of cash that remains from your sales revenue after all the company’s expenses (labor, materials, interest on the debt, and taxes) are subtracted. In a nutshell, profit is the difference between revenues and expenses. 

For example, if a restaurant’s revenue on a given day (food bills) equal to $5,000 and its daily expenses (food costs, labor, phone/internet) equal to $1,400, then the profit for that day is equal to $5,000-$1,400 =$4,400

Whether it’s a multi-national company or a retail store, every business’s goal is to earn more and more money; therefore profit is the ultimate sign of business success. Undoubtedly, your business can’t long survive without generating profit. 

However, there are a few types of profit that reflect your business’ profitability differently. 

Gross Profit

Gross profit is the amount of money you make after the cost of making a product or providing a service. It is calculated by subtracting the cost of goods sold (COGS) from revenue. 

Gross Profit = Revenue – Cost of Goods Sold (COGS)

Gross profit basically considers variable costs that change in proportion to production output such as purchase prices of goods, direct labor, shipping, materials used to manufacture products, commission, and more.

Operating Profit

Operating profit is the profit from business operations before the deduction of interest and taxes. In simple words, it’s the difference between operating expenses and gross profit.

Operating Profit = Revenues – Cost of Goods Sold – Operating Expenses – Depreciation and Amortization

Operating profit shows how well a company is controlling its business costs and how efficiently a company is making money from its core activities. 

Net Profit

Compare to other types of profit, net profit is the most accurate reflection of your business’ profitability. It represents the financial standing of a business after total expenses have been paid off from its total revenue. 

Net Profit – Gross Profit – Expenses

It is one of the most important factors because it shows the real health and success of your business. It also shows how much money you have to invest in your business and repay debts.

What is Cash Flow

Cash flow is the money coming in and going out of your business at any given time. In finance, it is the net amount of cash that is generated in a given time.

Cash inflow is the amount of money coming in from selling your products/services (income) and providing goods on credit (accounts receivable) to your customers. Whereas cash outflow is the amount of money going out from paying bills and wages (expenses) and receiving goods on credit (accounts payables) from your suppliers. 

Positive cash flow is when cash moving into your business exceeds cash moving out of your business at any given time. A positive cash flow indicates that your business has sufficient cash to cover day-to-day costs and other short-term business’ expenses. High positive cash flow allows you to determine problems with business liquidity and help you evaluate the quality of income, keep your business afloat during challenging times, and further grow your business. 

Why Cash Flow is More Important than Profit

A profitable business doesn’t mean you also have enough cash currently to run and grow your business. A profitable business can have negative cash flow. The reality is that profit can make your business strong on paper, but you can’t pay rent, meet payroll, and buy inventory without sufficient cash flow. Your company may have thousands of orders, great sales, and an amazing reputation, but without the ability to generate cash, it’s destined to fail. 

Here are some of the many reasons to monitor and strengthen your cash flow than profit.

Having enough cash means you can effectively and timely cover all your business expenses

Positive cash flow can help you boost your credit rating and have a positive impact on your business too

Since you have in the position to purchase inventory, hire talents, buy equipment, maintaining a positive cash flow means grabbing more business opportunities.

Healthy cash flow can help you prepare for critical uncertainties that may affect your business in the future and allows you to make better financial decisions. 

Maintaining positive cash flow can help you secure business financing, attract investors, promote your business, and meet your short and long-term business goals. 

 

To run a successful business, you need to keep track of both profit and cash flow. However, you also need to know that just because a business is profitable doesn’t mean it can pay its current financial obligations. That’s why your goals should be to increase your profit as well as boost your cash flow.