Profit and Cash Flow: Why it's important to know the difference
Before you take the first step on your entrepreneurial journey by starting a new business, you need to know the difference between ‘profit’ and ‘cash flow’.
At first it might seem like they measure the same thing—the financial health of your business. After all, for both it’s a case of the more you have, the better your business is doing. But profit and cash flow are two different beasts, and it’s important to know how each one affects your business.
Profit and cash flow in a nutshell
Profit is what’s left over after you’ve deducted your expenses from your revenue. That might sound simple, but there are a couple of important things to remember:
- Profit is a residual (i.e. “what’s left over”). It’s the result of what happens both in your business and to your business. You can’t increase your profits directly. Instead you have to either raise your revenue or lower your expenses.
- Profit doesn’t account for whether you’ve actually paid the expense or received the revenue. If you’ve invoiced a customer then it’s considered revenue, even if you haven’t received the money. Similarly, a product you’ve received but haven’t yet paid for it’s still considered an expense.
Cash flow is the amount of cash available to your business. It’s the difference between the cash your business pays and the cash it receives in its day-to-day activities. And here we’re talking about the actual money you pay suppliers and receive from your customers, rather than the ‘promises’ of money associated with profit.
The difference between profit and cash flow
One major difference between profit and cash flow is the way it’s produced.
There’s only one way to generate profit—by selling goods or services for more than what they cost to produce. But there are various ways to increase your business’ cash flow. You can add personal funds (which is often referred to as ‘capital’ or ‘equity’), or borrow money from banks, other lending institutions or even individuals.
While the best way to increase your business’ cash flow is through profits (which then creates new working capital), you may need to increase it from time to time to cover a temporary shortfall. This is often the case when first starting your business to cover large expenses such as plant and equipment purchases. (Don’t forget that you’ll need to repay the money you borrow, which will in turn reduce your cash flow.)
Why you need both
Many people think a successful business is one that’s making a profit. But for a business to survive long term it needs healthy profits and a healthy cash flow.
A business that can’t pay its bills when they’re due is considered insolvent. And trading while insolvent is against the law. So no matter how profitable your business is, if it doesn’t have the cash flow to cover the bills you won’t be in business for long.
But your business also needs to make a profit to maintain a healthy cash flow. As I mentioned earlier there are other ways to increase your business’ cash flow. But you don’t want to be pumping money into a business that’s failing.
The sustainable business model
If you want your business to be not only profitable but also sustainable, here’s what you need to do.
- Sell your products and/or services for more than what they cost to produce. (Make sure you factor in both fixed and variable costs.)
- Have systems in place to ensure any cash from sales is collected quickly and efficiently. Ideally it should be collected when your product or service is delivered —or even before.
- Use your profits to:
- pay yourself a wage
- pay your taxes
- re-invest in your business by purchasing the equipment and materials it needs to grow.
Just remember: You can only use the profits for those things if your business has a healthy cash flow.
How does profit and cash flow look in your business?
As you now know, profit and cash flow are quite different. But they have one thing in common: they are both vital to your business’ long-term success.
If you’re having trouble maintaining a healthy cash flow in your business, or would like to talk about ways to increase your profits, don’t hesitate to get in touch with us.
And make that first step on your entrepreneurial journey a memorable one.