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Comparing Cash Flow and Profit: What They Are and Why They're Important

Comparing Cash Flow and Profit: What They Are and Why They're Important
Susan Guillory
Susan GuilloryUpdated March 16, 2022
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Cash flow and profit may seem similar, but they are actually two very different ways to measure the financial health of your business. Cash flow is how much money is going into and out of your business at any given time. Profit, on the other hand, is how much the money your business is actually making once all costs are subtracted from revenue. Both cash flow and profit are critical to a company's success. Without positive cash flow, you won’t be able to keep the lights on and continue running your business. Without profit, you won’t be able to maintain positive cash flow. Read on to learn more about how cash flow and profit impact your business.

What Is Cash Flow & How Does It Work?

Let’s start by examining cash flow. Cash flow refers to the money that comes into your business from sales and the money that goes out through expenses. In other words, it’s the payments you are receiving and the payments you are making. If you have more money flowing in then flowing out, your business is considered cash flow positive. This enables you to pay for daily operations, taxes, purchasing inventory, paying employees, and handling any unexpected expenses. If you have more money going out then coming in, you are cash flow negative.Most businesses track cash flow on a month-to-month basis. You can do this by using a cash flow statement template. To fill it in, you add up all your cash on hand at the beginning of the month and put it in the box at the upper left-hand corner. You then fill in cash inflows and cash outflows throughout the month (actual cash in and out, not invoices or purchases).If your ending balance is higher than your starting balance, you’re cash flow positive for that month. If it’s lower, your cash flow is negative.

What Is Profit & How Does It Work?

Profit (also known as net income) is what you have when you subtract your expenses from your revenue. Ideally, you want as high a profit as you can get. Many things affect profitability, including what you charge for products and your expenses. If you can keep expenses low, you may be able to realize higher profits.There are a couple of versions of profit for you to be aware of, including:
  • Gross profit
  • Net profit

Gross Profit

Gross profit is the profit a company has after subtracting the costs directly associated with making its products or providing its services from revenues. These expenses, which are fully attributable to making a product or providing a service, are referred to as the cost of goods sold (or COGS) or cost of sales.If you sell furniture, your COGS might include fabric, padding, wood, glue, and nails. COGS can also include labor, shipping costs, credit card processing fees, equipment used to produce the furniture, as well as utilities for the building where you create the furniture. Let’s say you sell couches for $2,000. You have several expenses that go into making them:
  • Materials: $300
  • Shipping: $100
  • Labor: $200
  • Overhead: $300
Your total costs to make a single couch would be $900, which means your gross profit for each couch would be:2,000 - 900 = $1,100

Net Profit

Net profit more accurately reflects your company’s profitability. That’s because net profit factors in all costs, not just COGS. Once you’ve calculated net profit (revenue minus COGS) you then subtract operating expenses to get your net profit.Operating expenses can include payroll (for employees other than the ones making the product), marketing, rent, utilities, advertising, and administration costs. These are fixed costs that have to be paid regardless of how many products or services you make or sell.You can determine how much you spend per item by dividing the total you pay for all these operating expenses by the number of items you produce.So let’s say you have an additional $500 per couch of operating expenses on top of the $900 COGS. Your net profit would be:$1,100 (gross profit) - 500 = $600

Cash Flow vs. Profit

While being cash flow positive and profitable may seem pretty much the same at first glance, there are some key differences between cash flow and profit that are important to understand.

Similarities

Cash flow and profit are also both key indicators of a business’ financial health. If you apply for a small business loan, for example, a lender will want to see both healthy cash flow and solid profits. If either cash flow or profit remains insufficient, eventually, your business will be unable to continue operating. Both cash flow and profit depend on revenues and expenses and are important metrics used to create financial statements, such as balance sheets and income statements. Also, many businesses, especially startups, struggle with cash flow or profit at some point. Rapid or unexpected business growth can also cause a crisis in either profit or cash flow. 

Differences

When it comes to cash flow vs. profit, it is important to understand that you can be profitable while being cash flow negative. Profit on paper does not equal money in the bank.For example, if you have invoices to clients of $25,000 in a month and $20,000 in expenses, you have monthly profits of $5,000. However, if clients don’t pay until 120 days and suppliers need to be paid every 15 or 30 days, you might not have the cash to pay them, meaning you are cash flow negative. It is possible for a business to be profitable yet unable to pay its bills.By the same token, growing and having steady cash flow can make you feel flush, but it does not mean you are making a profit. For example, if you take out a small business loan to get an influx of working capital, you’ll have adequate cash flow for your company. However, if the monthly cost of the debt is higher than your monthly break-even point, your company would not be making a profit.Recommended: Understanding Different Types of Small Business Loans 

Cash Flow vs. Profit in Accounting

When it comes to accounting, the method you use will impact how both cash flow and profitability appear in your financial statements. Let’s look at cash vs. accrual accounting methods.

Cash Basis Accounting

With the cash basis accounting method, you record business expenses and profits when they hit your account. You might invoice a client on the first of the month, but you wouldn’t include that as revenue until the client pays the invoice and the funds show up in your bank account. This is a simple way to manage your finances and gives you an accurate picture of how much cash you currently have available to spend. However, it isn’t the best way to gauge your company’s profitability.

Accrual Accounting

With accrual accounting, you count revenues and expenses when they are posted, meaning when you send that invoice to a client, you count it as revenue, even if the client hasn’t paid it yet. Likewise, you count expenses when you receive a bill from a vendor. This won’t give you a true picture of monthly cash flow, but it can give you a more accurate view of your company’s profits.

The Takeaway

When comparing cash flow vs. profit, you’ll want to keep in mind that profit is the revenue remaining after deducting all costs associated with operating the business, while cash flow is the amount of money flowing in and out of a business at any given time. While profit can tell you if your business is successful or not, it doesn’t tell you if you have enough cash to pay your bills. On the other hand, if you have a positive cash flow but your business isn’t profitable, it will be difficult to stay cash flow positive for very long.It’s important to consider both cash flow and profit when making business decisions. If you’re thinking about taking out a small business loan, for example, you’ll want to make sure that the influx of capital will not only improve cash flow, but also allow you to make investments that will boost profits. Those higher profits will, in turn, boost cash flow.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Photo credit: iStock/chingyunsong The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC0122029

Frequently Asked Questions

Is cash flow or profit better?
Is cash flow equal to net profit?
Is profit included in cash flow?

About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
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