The basics of cash flow versus profit
Cash flow and profit are often confused, but they’re actually two independent metrics. Understanding how they differ and interact with each other can help you to better manage your business and finances.
What is cash flow?
Cash flow is the movement of money into and out of your business over a specific period of time. There are three main types of cash flow: operating, investing and financing.
Operating cash flow is money that is directly involved with the production and sale of goods or services during ordinary business operations. These figures are used to determine if your business has enough funds coming in to pay your bills and cover your usual operating expenditures.
Investing cash flow is how much you’ve spent or generated from investment-related activity within a specific time period. Negative cash flow in this area isn’t necessarily a warning sign as you may be investing more to gain future returns, such as in research and development (R&D).
Financing cash flow shows the net flow of cash used to fund both your business and its capital. Unlike operating cash flow, financing includes all transactions including issuing debt, equity and paying dividends. Financing cash flow helps investors determine a company’s financial strength and how well it’s being managed from a financial standpoint.
Understanding cash flow is vital to the success of your business. Having a healthy cash flow means you can cover your fundamental operational costs as well as your short-term obligations without overstretching your budget. Having good cash flow can also help you weather any future financial challenges and provide you with the flexibility needed to ensure your business’s continuity.
Xero’s cash flow calculator is a great way to get a steer on how your business is tracking month to month so you can plan ahead with confidence.
What is profit?
Profit is the financial gain a business earns after deducting all expenses from its revenue. There are three different types of profit: gross profit, operating profit and net profit. Understanding profit (and the different types) is crucial to making sure your business is truly profitable and measuring your business’s health.
Gross profit is the first step in determining profitability. This is simply the sales figure minus the cost of the goods sold.
Next is operating profit. This takes your profit analysis a step further by deducting the operational costs (e.g. rent, energy bills, employee salaries) from your sales figure.
Net profit is the final step (and figure) after everything has been deducted from your sales including any interest and taxes you’ve paid. As it’s the final step in determining your ‘real’ profit it is also called the bottom line. This will be the amount you have left when accounting for all of your business costs.
It’s crucial to understand the different levels of profit to get an accurate picture of your business’s health. For instance, it’s possible to have a healthy gross profit but once you deduct operational and net costs you may be left with a negative figure, meaning your company is ultimately not profitable.
The key differences: Cash flow versus profit
So what is the difference between cash flow and profit?
Cash flow only refers to the money that flows in and out of your business within a specific time frame, whereas profit is what is left from your revenue once you’ve deducted your varying levels of costs (operational, taxes etc).
It would be easy to mistake profit as the key indicator of how your business is doing. Large profits equals a strong business, right? However, it can be a little more complicated than that. Whilst your profit shows short-term success, cash flow can provide a more comprehensive view of how well your business is doing overall.
For instance, you could have a profitable business but poor cash flow. If you have poor cash flow you won’t be able to make the payments necessary to produce goods as you won’t be able to pay your suppliers or staff. This means that, though your business has been profitable and you’re selling something that is in demand, your business may end up stalling due to insufficient cash flow.
If you have great cash flow but not a lot of profit, you may need to consider if your business goals are sustainable in the long term. This may include considering if there are more profitable products or services to sell, or more cost-effective ways of producing them.
Cash flow and profit in financial analysis
Analysing your business’s cash flow is a useful way to understand if your business has the ability to generate and manage cash effectively. In comparison, when analysing your profits you’ll be able to assess your business’s financial performance, profitability and potential for growth.
Cash flow versus profit: A real-world example
There can be times when a business is profitable but can still have a negative cash flow. Let’s take a look at a cash flow versus profit example.
Say you run a construction company and own a parcel of lucrative land that you intend to build on. During the construction phase, if you don’t have enough cash flowing into the company your construction project may stall as you’ll be unable to pay contractors and buy building supplies.
In this instance, you may still be seen as profitable on paper as you have a lot of initial investment money tied up in your assets (such as the land value). However, you don’t have the cash to hand needed to fulfil your building project.
Having poor cash flow will cost you precious time and money, as you have to wait for your cash flow to pick up in order to finish the build and access your profits. Or, in the worst-case scenario, you may have to abandon your project and sell the land to recoup your initial investment.
In this scenario, you’d need to carefully monitor your construction cash flow to ensure you’re able to complete each stage of your build, whilst also keeping an eye on costs to achieve a profit. It’s therefore important as a business owner to keep an eye on both profit and cash flow in order to have a comprehensive financial picture of your business.
Striking the balance: Cash flow and profit harmony with Xero
You can use accounting software such as Xero to track and analyse both your cash flow and profit. You can generate real-time financial reports to identify trends and make smart financial decisions, along with automating your financial processes. Overall, Xero can help streamline operations and improve business efficiency.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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