When it comes to the financial health of your business, both cash flow and profit generally play vital roles. However, they are not the same thing. To thrive, a successful small business must generate profit and maintain a positive cash flow simultaneously. Let's explore the important distinctions between cash flow and profit and how you may better manage both in the current business landscape.
What are the two types of profit?
There are two types of profit: gross profit and net profit. Gross profit is revenue minus the cost of goods sold. In other words, gross profit describes a small business's profit after subtracting the costs involved in producing and selling its products and services. Notably, gross profit does not include fixed costs, such as rent, that remain unchanged as a small business’s level of output or amount of service provided varies. Gross profit is among the data listed on a small business’s income statement.
On the other hand, net profit is calculated by subtracting all business expenses, including both the cost of goods sold and fixed costs, from the revenue. It reflects the amount of money a small business retains after covering all operating expenses. In some cases, net profit may also be defined as a small business's pre-tax profit minus its tax obligations.
Cash flow refers to the net amount of money flowing in and out of a company. It indicates a company's liquidity to handle unexpected expenses promptly. Cash flow is generally categorized as positive (more revenue than costs) or negative (more costs than revenue). Both these definitions resemble the meaning of profit, though the cash flow vs. profit divide is typically easier to understand than many think. Learning how to analyze your cash flow may help you better manage your business.
The differences between profit and cash flow
One of the main differences between cash flow and profit is that cash flow measures how much money is available to your small business at any given point. In contrast, profit describes the amount of money that your products and services are bringing in. In other words, cash flow may paint a better short-term picture of funds as opposed to profit.
The below examples may help to clarify the difference between cash flow and profit:
Profit increases when your business generates revenue, but that doesn’t necessarily mean you’ll have cash on hand. One major difference in positive cash flow vs. profit is that a business will generally only have cash available for paying off its expenses if newly generated revenue turns cash flow positive.
For example, a business that sends out an invoice for $5,000 may add $5,000 to its revenue, but, until the client pays this invoice, this $5,000 cannot be added to cash flow. Cash flow positive vs. profitable are thus different distinctions.
Sometimes, a business pays for an expense before receiving the corresponding product or service. For example, if a company spends $500 on a new product that it plans to sell for $600, it doesn't have that $500 available in its cash flow initially, even though the net income from the sale will eventually be $100. Despite the initial $500 dip, profit still increases by $100 when the sale is made.
In the instance of the $500 product sold for $600, the $100 revenue can be marked immediately upon the sale’s completion. However, the $100 profit cannot be marked until the money arrives and gets added to the business’s cash flow. This example further highlights the distinction between cash flow and revenue.
The difference between cash flow and profit and loss
Just as your business may sometimes post a loss rather than a profit, it may also have plenty of cash flow while still posting a loss. For example, consider a situation in which your business owes $1,000 in outstanding invoices. If your company has just brought in enough revenue to shore up $800 in positive cash flow, you will now have cash on hand, but still need more to pay your invoices. If you have additional time before invoice payments are due, you may choose to keep your cash flow positive vs. being profitable until you bring in more cash to make these payments and eliminate your negative net income.
How to achieve proper cash flow management
If earning a profit while not having cash readily available concerns you, consider looking at cash flow management options to keep your business liquid. Begin by creating a cash flow statement that may help you determine which of your business operations add the most to your cash flow, whether positively or negatively. If you can readjust your business strategy to prioritize operations that bring in cash, then doing so may turn your cash flow positive more quickly.
You may also make simple, long-lasting business changes to increase your cash flow. For example, invoicing your clients regularly rather than sporadically teaches your clients to pay you on a regular, recurring basis that helps you predict when your cash flow vs. revenue balance favors the former rather than the latter. You may also apply for small business loans that increase the cash you have immediately available for use toward sales-boosting projects.
The importance of cash flow in business
The importance of cash flow in a business cannot be understated. In fact, in the positive cash flow vs. profit debate, some experts may say that achieving consistent positive cash flow may be more important than turning a profit, as many well-known companies remain in the red for several years – even during times in which they are often bought from or turned to for their services.
Even a business that isn’t profitable needs to have cash available for business transactions. Positive cash flow gives a business the following qualities:
- Stability. Even if your business isn’t yet profitable, positive cash flow may increase your buying power while preventing debt and protecting your credit score from falling too low.
- Debt protection. Relatedly, positive cash flow allows you to pay off debts – which are typically inevitable for small businesses, especially in their early stages – and help keep your company’s credit and reputation in good standing.
- Growth. When you have cash to spend, growing your business becomes easier. You may feel hesitant to take out loans or borrow money for growth-related spending if you can’t guarantee the positive cash flow to ultimately pay these loans back.
- Better loans. Although you may need loans to achieve positive cash flow, loans can be hard to secure without positive cash flow in the first place. Lenders are more likely to fund loans with rates and terms that are better for your business if you can demonstrate positive cash flow.
If your business has positive cash flow and good credit, you may be eligible for low-cost SBA loans that can help you grow your business. Apply for an SBA loan through SmartBiz to determine whether you’re pre-qualified for a low-rate and long-term loan with no prepayment penalty (with no impact to your credit score*).