Cash Flow vs. ProfitWhat's the Difference?
If you’re a new business owner, you might mistake cash flow and profit as the same thing.
Let me tell you now though that they’re not.
They’re different things, and knowing each of them will help you in understanding your business better.
Have you ever wondered why the net income figure you see on your income statement doesn’t always translate to an increase in your cash?
Or that sometimes, you may have an inflow of cash but it’s not due to a sale?
Well, that’s because profit and cash flow aren’t always equal.
You can have profit without cash flow.
Likewise, you can have cash flow without profit.
Though they are different, cash flow and profit are both important metrics in assessing a business’s financial performance and health.
That’s why understanding both of them, as well as knowing what makes them different is essential for any business owner (or investor).
Having a good understanding of both makes it easier to gauge whether a business is actually profitable.
Not only that, but it also helps in assessing it the business can stay afloat no matter the state of the economy.
In this article, we will be learning about the two terms: cash flow and profit.
We will first define each and then make a comparison.
What do they mean for a business?
What are the differences between the two?
Is one more important than the other?
Why can I have profit without cash flow and vice versa?
Read on to find out.
What is Cash Flow?
Cash is the most liquid asset.
As such, it’s no wonder why it’s constantly moving in and out of a business.
This constant moving in and out is what we refer to as cash flow.
To be more specific, when cash moves into a business, we refer to it as cash inflow.
When cash moves out of a business, we refer to it as cash outflow.
For example, when you make a sale and the customer pays for it with cash, cash moves into your business.
That means that there is cash inflow from such a sale.
Another example of cash inflow is when a business receives a cash injection from its owner/s or investor/s.
As for a cash outflow, an example would be is when a business purchases suppliers or inventory with cash.
Another is when a business pays for operating expenses such as rent, utility, maintenance, and employee compensation (salaries and wages).
Also, there is cash outflow when a business pays its debts.
Depending on how much cash inflow and outflow there is, cash flow can either be positive or negative.
When cash inflow outweighs cash outflow, there is positive cash flow.
On the other hand, when cash outflow outweighs cash inflow, there is negative cash flow.
In general, you would want to have a positive cash flow for your business.
It means that more cash is moving into your business than what’s going out of it.
That said, a negative cash flow isn’t necessarily a bad thing.
It could mean that the business is growing or expanding and as such, is using cash to purchase certain assets.
The Three Categories of Cash Flow
We can categorize cash flow depending on its source: operating, investing, and financing.
Operating Cash Flow
Operating cash flow refers to the net cash flow that comes from a business’s main operation.
For example, when a business receives cash for a successful sale, there is an operating cash inflow.
When a business pays for its operating expenses with cash, there is an operating cash outflow.
Ideally, a business would want to have positive operating cash flow.
It means that the business was able to generate more cash than its spending.
Also, a positive cash flow is often required for business growth.
Investing Cash Flow
Investing cash flow refers to the net cash flow that comes from investing activities.
Examples of investing activities include the following:
- Purchase of capital assets such as machinery and equipment
- The sale of long-term assets
- Investing in short-term or long-term financial instruments (e.g. stocks, certificate of deposit, bonds, etc.)
- Receiving dividends from the stocks (of another business) that a business is holding
In a growing or expanding business, investing cash flow will almost always be negative.
This means that the business is using cash to invest in capital assets such as machinery and equipment.
Financing Cash Flow
Financing cash flow refers to the net cash flow that comes from financing activities.
This specifically refers to the cash flow between the business and its owners, investors, and/or creditors.
For example, when a business receives an injection of cash from its owners or investors, there is a financing cash inflow.
Other examples of financing activities:
- Declaring and distributing dividends
- Taking out a loan
- Making interest and principal payments
- Receiving donated capital
What is Profit?
What you earn from sales isn’t what a business truly earns yet.
To make such a sale, the business would have to incur costs such as the cost of the merchandise that it’s selling.
In addition, there operating expenses to consider such as rent, maintenance, and employee compensation.
Not only that but there are also non-operating expenses such as finance charges (e.g. interest expenses) and taxes.
What’s left of the revenue after considering all these expenses is what the business truly earns. And we refer to it as profit.
Depending on the business structure, profit can be utilized differently.
In a sole proprietorship, the sole owner can either reinvest it in the business (for growth) or withdraw it.
In a partnership, the partners will each have a share of the profits depending on their agreement.
Profit can either be negative or positive. If revenue outweighs all expenses, there is positive profit, or simply, profit.
If the total expenses outweigh revenue, there is negative profit which we commonly refer to as a loss.
Ideally, a business would want to always report positive profits. It means that the business is reliably earning from its main operations.
On the other hand, reporting a loss means that the business did not earn a profit for that period.
What’s even worse is that that business incurred more expenses than what it earned as revenue, meaning that it lost money.
A loss may be normal for a newly-formed business that is only starting to find its footing.
For an already established business, a loss is alarming.
Gross Profit, Operating Profit, and Net Profit
We can categorize profit depending on what expenses we deduct from it.
Do note that all of these profit categories appear on an income statement.
Gross profit is what we get when we only deduct the cost of sales from a business’s revenue.
Cost of sales refers to expenses that are directly attributable to the generation of a sale.
For example, the cost of merchandise that the business is selling.
In a manufacturing setting, the cost of sales will include the cost of direct materials, direct labor, and manufacturing overhead.
Gross profit is an important metric as it helps gauge if the business is setting an appropriate price for its products/offerings.
If gross profit is positive, it means that the business has set an appropriate sales price.
It can also mean that the business is earning from its sales.
On the other hand, if gross profit is negative, the business will not be earning any profits as there are still other expenses to consider.
Gross profit also helps gauge the efficiency of a business’s operations.
Speaking of operations…
Operating profit (a.k.a. earnings before interest and taxes or EBIT) is what we get when we deduct the cost of sales and operating expenses from a business’s revenue.
Unlike gross profit which only considers the cost of sales, operating profit also considers operating expenses.
As such, operating profit measures the profitability of a business’s main operations.
Operating profit will always be less than a business’s gross profits as it considers more expenses.
It considers operating expenses such as rent, maintenance, transportation, employee compensation, etc.
Same with gross profit, a business would want a positive operating profit figure.
It means that the business is able to generate enough revenue to cover all costs of operations.
Net profit (a.k.a. net income) is what we get when we deduct all expenses from a business’s revenue.
By all expenses, I mean that even non-operating expenses are included.
Non-operating expenses usually consist of finance charges (e.g. interest expenses) and taxes.
Net profit is what a business truly earns.
It’s the bottom line figure of an income statement.
It’s ultimately what goes back to the business in the form of retained earnings. Or it’s what the business distributes to its owners.
Cash Flow vs Profit
Now that we defined both cash flow and profit, we can now proceed with the comparison.
What information does it tell us?
Firstly, cash flow and profit tell us different information.
Cash flow tells us how much cash is going in and out of the business.
It is laser-focused on the movement of cash.
On the other hand, profit tells us how profitable a business is.
It does not only focus on cash.
It considers anything that can affect a business’s profitability such as revenue and expenses.
In short, it tells us the amount that the business has earned for a certain period.
Which financial statement can we find it in?
You can find information about a business’s cash flow from its statement of cash flow (or cash flow statement).
In it, you’ll find information about a business operating, financing, investing, as well as the net cash flow.
You can find information about a business’s profit from its income statement (or P&L statement).
In it, you’ll find information about a business’s revenue as well as all of its expenses.
Cash flow gauges stability and solvency; Profit gauges profitability for a certain period
Profit gauges a business’s profitability for a certain period, meaning that it’s great for measuring a business’s immediate success.
On the other hand, cash flow looks at how much cash the business has.
It helps in gauging the solvency of a business, which can be a long-term concern.
A business can be profitable even with poor cash flow
Profit does not always mean that there is cash inflow.
This is the case when a majority of the business’s sales are credit sales.
The thing with credit sales is that the business does not immediately receive cash when it makes the sale.
Instead, it will receive cash at a later date.
There will be a discrepancy between profit and cash inflow if the collection from credit sales happens in another period.
Also, a negative cash flow doesn’t always mean that the business is doing bad (it only is when the cause is due to negative operating cash flow).
It could mean that the business is using cash to invest in capital assets to facilitate business growth or expansion.
On the other hand, a good cash flow does not always mean that the business is profitable.
This is the case when most of the cash inflows come from non-operating activities (financing and investing).
When looking at a business’s cash flow statement, take a look at the operating cash flow.
If it’s positive, it means that the business is profitable for that period.
Which is More Important? Cash Flow or Profit?
The short answer to this question is no, cash flow and profit are both equally important.
Both are important financial to gauge a business’s financial health and condition.
And each tells us a different story, so it’s not like profit can substitute cash flow or vice versa.
In the short run, business owners might value profit over cash flow.
This isn’t necessarily wrong.
When a business is still new, its source of cash may still be limited.
As such, the business would want to focus first on a steady stream of profit.
In the long run, a business would want to put emphasis on its cash flow, especially when it has already an established profit stream.
Cash is important to maintain a business’s liquidity and solvency.
As such, the business would want to have good cash flow while still being profitable.
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