Both cash flow and profit are key to the health of your business, but the answer to the oft-asked question “Is cash flow profit?” is a resounding no. A successful small business must eventually both generate profit and maintain a positive cash flow. Read this article to learn about the most important differences between cash flow and profit, and how you can tend to each one.
What are the two types of profit?
There are two types of profit, gross profit and net profit.
The exact definition of gross profit is revenue minus the cost of goods sold. In other words, gross profit describes the profit a small business makes after subtracting the costs involved in producing and selling its products and services. Notably, gross profit does not involve 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.
The exact definition of net profit is revenue minus all business expenses – both the cost of goods sold and fixed costs. It describes the amount of money a small business has left after all operating expenses are paid. In some cases, net profit can also be defined as a small business’s pre-tax profit minus its actual tax.
Cash flow in business describes the net amount of money a company is taking in and spending. Cash flow is indicative of a company’s liquidity to pay for unexpected expenses on short notice. Usually, cash flow is defined as either positive (greater revenue than costs) or negative (greater costs than revenue). Both these definitions resemble the meaning of profit, though the cash flow vs. profit divide is easier to understand than many think.
The differences between profit and cash flow
The main difference between cash flow and profit is that cash flow measures how much money is available to your small business at any given point, whereas profit describes the amount of money that your products and services are bringing in. In other words, cash flow may paint a better instantaneous or short-term picture funds than profit can.
The below examples may also help to clarify the difference between cash flow and profit:
1. Revenue generated
Profit increases when revenue is generated, but that doesn’t mean you’ll have cash on hand. A major difference in positive cash flow vs. profit is that a business will only have cash available for paying off its expenses if newly generated revenue turns cash flow positive.
This difference may be better understood with an example. A business that sends out an invoice for $5,000 can 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.
2. Expense incurred
Sometimes, a business will pay for an expense before the product or service paid for arrives or becomes usable. For example, a business that spends $500 on a new product it plans to sell for $600 does not have that $500 available in its cash flow even though the net income from the sale will ultimately be $100. And when that sale is made, profit likewise increases by $100 despite the initial $500 dip.
3. Profit recognized
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 with the business and gets added to its cash flow. This case also helps to address the cash flow vs. revenue distinction.
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 has $1,000 to pay in outstanding invoices. If your business has just brought in enough revenue to shore up $800 in positive cash flow, you will now have cash on hand, but still not enough money to pay your invoices. If you have some more 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 can help you to 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 sooner than later.
You can 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 can 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 might say that achieving consistent positive cash flow may be more important than turning a profit, as many ubiquitous 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 non-profitable business 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 increases 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 almost inevitable for small businesses, especially in their early stages – and keep your company’s credit and reputation in good standing.
- Growth. With no cash to spend, growing your business becomes tougher. 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 Loans to find out whether you’re prequalified for a low-rate, long-term loan with no prepayment penalty.