The two most common indicators of business success or failure are cash flow and profit. Many people understand profit as the difference between revenue and expenses. Cash flow, on the other hand, is seldom known but often confused with profit.
It is the total amount of money in and out of a business. Of the two, profit is seen as the better measure for business success. This is a false notion. In actual sense, a business may be turning a profit but has no money to sustain its daily operations.
A growing business may have recorded a profit in its books at the end of a business year but have no money in the bank to show for it. Take, for instance, a motor vehicle dealership that sales inventory worth $30,000 on May 1st.
Total expenses on the inventory were $20,000. The books of account will read that this business made a profit on May 1st. However, since the customers do not pay until the end of September, there is no money in the account hence no operating expenses. This business has a negative cash flow. The inverse is also possible. Cash flow may be positive when no profit is being realized.
Managing a business requires an entrepreneur to pay close attention to both cash flow and profit. This article will highlight the differences between the two measures for better business management.
The goal of every aspiring entrepreneur is to grow a profitable business. At a glance, profit is the basic metric that shows the success of a business. It can be defined simply as the revenue left after subtracting business expenses from sales revenue.
For instance, if you buy and old spade at $10, refurbish it for $8 and later sell it for $40, your profit will be the $40 less $18, which is $12. In business, is it never quite as simple? There are various ways to calculate profits so that the true position of the business is determined.
Gross profit is the gain realized when the cost of goods sold is removed directly from the sales. The computation of gross profit only takes into account expenses that are directly associated with the production process. Other expenses are not included at this stage. It is only a primary measure of the position of the company.
Net profit is a better indicator of profitability than gross profit. It takes into account liabilities, alternative forms of income, discounts, taxes interests on loans, and operating expenses such as electricity and phone bills.
In the day-to-day operations of a business, money is required to finance various activities such as buying stock, delivery, and paying utility bills. This “money traffic” at any given time is cash flow. Seasoned entrepreneurs insist that cash flow is a better way to measure how a business is performing and how it will perform in the near future.
Normally cash flow is measured on a monthly basis. Positive cash flow indicates that more money is coming into the business, while negative cash flow means that the business is spending more than it is making.
While positive cash flow is symptomatic of a healthy business, negative cash flow could result in bankruptcy or insolvency. It is important to note that cash flow is only concerned with the movement of cash. A cash flow statement does not show any pending invoices or credit purchases. This is why a business might seem profitable but has no operating expenses.
Sometimes a positive cash flow does not mean profits. If, for example, the money used in everyday expenses is borrowed, the costs of the debt will eventually increase the cost of operation above the breakeven point.
Differences between Cash flow and profit
In Relation to Income and Drawings
Income affects cash flow and profit in different ways. While income from other sources such as a bank loan might indicate a positive cash flow, it will eventually increase the liability of the business and thus decrease profits. In the same vein, cash outflows such as drawings negatively affect cash flow. However, they do not affect the profit of the business since they are not factored in calculating profit. Changes to capital are reflected in the business’s balance sheet rather than its profit and loss statement.
In Relation to the Time of Accounting
Different financial statements give different information depending on the time of reporting. The cash flow statement, for instance, will only indicate monthly movements of cash. It, therefore, does not include purchases and sales made on credit.
A profit and loss statement will indicate the financial position of the business at the end of the financial year. It will include both cash transactions and credit transactions. However, it will not take into account any changes in capital.
Financial statements may be reported on an accrual basis or a cash basis. The accrual basis of accounting considers the instance of the expense or income. It is immaterial that money changed hands or not. Cash basis, on the other hand, will only record when revenue is received in business. It is the more prevalent basis for accounting.
When using an accrual basis of accounting, profits will seem to be lower than the cash basis. Cash flow might also be negatively reflected. Prepayments are not considered in the accrual basis since the instance of revenue has not yet occurred.
Both cash flow and profit will give information about the position of a business. Profits will immediately tell a business owner that they are doing well, at least with regard to sales. Profits will also give a general assessment of the business throughout a financial year. It is, however, difficult to discern the day to day inflows and outflows of business by just observing profit margins.
Cash flow, on the other hand, gives the business owner accurate information on how money is being spent. This information can be used to forecast the business’s outlook in a few months to come. A prudent business owner should know how to balance cash flow with profit and observe both with the keen eye of an eagle.