Understanding profit and cash flow: what is the difference, and why does it matter?06/09/2023
You have probably heard people use the terms “cash flow” and “profits” interchangeably. As a business owner, it is vital that you do not fall into this habit, because mixing these financial measurements up could have serious ramifications for your organisation. You will keep your business in better financial health – and be empowered to make better decisions – if you understand what these terms really mean, and why they are different. Here is a brief primer on cash flow and profitability to help you distinguish between the two.
Understanding cash flow
The net amount of cash flowing into and out of your organisation is referred to as cash flow.
Positive cash flow indicates that you have more money flowing in through sales and other inputs than you are spending on operational costs, wages, and so on. Negative cash flow is the inverse of positive cash flow, with more money going out of the firm than entering in. Unlike profits, cash flow represents your business’s liquidity at any one time.
Profits are the surplus that remains after deducting all costs from your revenue. Profits should be visible on your bookkeeping records if you have developed a sound business plan (and contacted a professional accountant). Profits on paper, however, may not necessarily transfer into cash in your bank account.
Profits are reported on an accrual basis, which means they are recorded as soon as the transaction is completed, regardless of when the cash is received. Cash flow tracks money as it enters or exits your bank account, making it a more precise indicator for determining how much cash you have available to spend.
Non-cash expenditures are frequently included in profit estimates, such as depreciation or amortisation. These metrics have the potential to skew your picture of actual cash in hand.
Investment capital: A positive cash flow allows your organisation to invest in new prospects without relying on outside funding. Even if profits are large, they may be locked up in receivables or inventories and may be difficult to retrieve. A large cash flow implies easy access to funds, which is not necessarily the case with earnings.
Why you need both
Understanding profits and cash flow will make running your business successfully much, much, easier. Here are some of the ways it can impact your organisation:
Strategic planning: Understanding your profit allows you to make long-term strategic decisions and analyse the profitability of new ventures. It determines whether your business can expand and sustain itself in the long run.
Day-to-day operations: Positive cash flow means that you can handle your immediate needs, like wages and inventory purchases, without using credit or outside funding.
Investor and lender attractiveness: Both are important measures for stakeholders. While profits make you more appealing to investors, lenders usually use cash flow to determine your capacity to repay loans.
Using cash flow and profits
Profits and cash flow are both indications of a business’s financial health, but they serve different functions and should be assessed equally effectively by a skilled accountant. Understanding these two essential criteria means you are more prepared to make educated decisions that contribute to the long-term profitability and stability of your organisation.
If you need help sorting out your profits from your cash flow, contact JW Hinks on 0121 456 0190 and speak to our friendly team of experts.