Cash flow and profit are two important financial parameters for determining the health of a business. Many business owners are eager to look at financial statements in order to determine how to plan ahead, but they often get mixed up on how to properly interpret financial data.
One of the most common questions is, "Should I focus more on the cash flow vs profit to analyze the health of my business?" For business owners, understanding the relationship between cash flow vs profit can help inform key business decisions, including the best way to pursue growth.
However, you're not alone, and the team at John F. Dennehy can help. We are a team of skilled CPAs, business consultants, and accountants with decades of experience helping business owners simplify complex data and reports. Let's take a closer look at cash flow, profit, and the key differences between the two.
Understanding Cash Flow
Money that flows in and out of a business through everyday transactions is referred to as cash flow. Examples of cash flow are when:
On any given day cash flow can either be positive or negative, but it doesn’t necessarily mean the business is doing well or poorly overall. Cash flow is often used as a metric to measure a business’s short- and long-term goals, which means most businesses monitor it on a month-to-month basis. If you need help with tracking your business’s cash flow, check out our other article titled 7 tips to small business expense tracking to learn more.
Three Types of Cash Flow
In addition to positive cash flow and negative cash flow, it can be further broken down into three major categories:
Operating Cash Flow
The operating cash flow refers to the net cash created from your normal business operations. When you're expanding and growing, positive cash flow is necessary to sustain growth.
Investing Cash Flow
This cash flow refers to net cash created from your investing activities, such as:
Financing Cash Flow
Financing cash flow is cash that moves between your creditors, owners, or investors and your company. This is the cash that is created to finance the company and may include dividend payment, equity, and debt.
Understanding Profits
Profit or net income is the money that remains after a business has deducted all its expenses (e.g. suppliers, payroll, utilities, etc.). In other words, if a business’s monthly revenue is $20,000 but it cost $17,000 to generate that $20,000, then the profit would be $3,000.
However, when it comes to profits, there are two different calculations used to illustrate a business’s profit margin: gross profit and net profit.
Gross Profit
Gross profit is generated by deducting the costs associated with providing services or making products. To calculate it, simply subtract business revenue from the cost of goods sold (COGS) or cost of services (COS). COGS are all expenses that you can directly link to the production of goods sold while COS refers to direct labor costs in order to provide the service.
Net Profit
Net profit more accurately reflects a business’s profitability compared to gross profit because it factors in liabilities not associated with COGS. Net profit can be found by subtracting COGS (or COS), interest from revenue, taxes from revenue, and overall operating costs. Operating costs include expenses such as payroll, loan payments, rent, and anything else that does not directly connect to business offerings.
Cash Flow vs Profit: Which One Is More Important?
With both terms clearly defined, should one measurement be taken into consideration over the other? The short answer is no, each provides a unique input into a business's affairs.
For example, a company can generate positive cash flow without generating profit if the cash comes from sources outside of income, such as a business loan or when an owner puts in their own capital. These types of transactions will appear as a liability or equity transactions on a balance sheet rather than income.
Conversely, a company can spend significant cash flow while still generating profit. This can happen when an owner takes out cash to pay non-business-related expenses or uses the money as an investment towards a new initiative.
Therefore, for a business to stay afloat, there often needs to be an offset of cash flow and profit throughout the year. If you are a business owner trying to find the right balance for your company, it's important to find ways to improve and simplify your expense tracking strategy in order to see where adjustments can be made to increase profits.
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The key difference between profit and cash flow is that cash flow indicates the net flow of cash in and out of your business; while profit indicates the amount of money remaining after all expenses have been paid. Profit shows how successful a business is, but it can’t determine if there is enough money to maintain operations long term.
On the other hand, cash flow can be inconsistent at determining where a business currently stands, but it is a useful measure for short- or long-term business goals. Simply put, it's important for business owners to understand and strategically manage both metrics for the health of your company.
Contact John F. Dennehy CPA today for expert accounting solutions.