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It’s incredibly crucial for successful businesses to balance profit and cash flow to ensure there is an opportunity for growth while staying operational in the short term.
Understanding the differences between cash flow and profit can help monitor financial performance and evaluate the business in the best way possible to quickly spot issues and potential opportunities.
This article will look at profit vs cash flow, including cash flow, profit, and how the two differentiate.
|Table of Contents|
Let’s first establish how cash flow and profit is different in definition.
Cash flow refers to the total inflow and outflow of cash coming in and out of your business.
Profit is essentially revenue, minus expenses incurred by the business - it looks at how much money is left after the business has accounted for its expenses.
|Definition||Inflow and outflow of cash and cash equivalents generated by normal operation of a business||Money that remains after a business had paid all of its expenses|
|Calculation||Calculated by adding or subtracting operating, financing, and investing costs that a business incurs by using a cash flow statement.¹|
|Participation in business health||Used for measuring liquidity and as a metric to evaluate and manage operational costs, spot markers of financial distress and monitor financial health.||Profit indicates the performance of the business and shows how much money it has earned.|
Now that key differences have been established, it’s time to look at cash flow individually.
At its core, cash flow is a metric used to understand the inflow and outflow of cash and cash equivalents incurred as the business operates.
Positive cash flow can suggest that the business is performing well and has the resources needed to grow.
For example, a business with positive cash flow is better positioned for stock buyback and repaying debts.
Additionally, businesses can use positive cash flow strategically by expanding to new locations, increasing inventory, and more.
However, consistently positive cash flow could be a sign that a business should consider reinvesting in itself to accelerate growth.
On the other hand, negative cash flow needs more scrutiny as the source of the negative cash flow will indicate whether a business is potentially in trouble.
For example, if negative cash flow occurs due to investing in the business itself, or paying back debt, it can be a short-term issue with long-term gains.
However, if negative cash flow is occurring due to expenses, it requires more attention.
Negative cash flow can lead to financial distress and bankruptcy down the line.⁵
Which is why you will need to be strategic about alleviating negative cash flow to ensure your business can operate as normal and grow.
When undertaking cash flow analysis, there are three major types of cash flow considered, as seen below.
Operating cash flow looks at cash inflow and outflow related to business operations.
Examples of operating cash flow can include:
- international payments to suppliers (and fees incurred),
- employee wages,
- office expenses across different locations, and more.
Cash flow from investing activities includes cash inflow and outflow related to business investments.
Examples of investing cash flow can include:
- purchasing equipment for the business
- acquisitions, and income generated from purchasing or selling stocks, bonds, and other securities.
Cash flow from financing is cash inflow and outflow from financing activities.
Examples of financing cash flow can include:
- issuing or repaying equity
- issuing debt or repayments, and dividend payments, among other financing options available to a business.
A cash flow statement is a primary method for analysing cash flow. It can shed insight on the state of current cash in a business and demonstrate which areas take up the most inflow and outflow.
A cash flow statement can help monitor cash flow and list out the different cash flow types to help you understand how your business manages cash in and outflow.
Before looking at profit, let’s first establish what revenue is as the two are connected.
- Revenue refers to money a business earns through selling its products and services.
- Profit refers to the money that remains after deducting all expenses from revenue.
You can calculate profit by using the following formula:
|Revenue – Cost of Goods Sold (COGS) = Gross Profit|
In this formula, the Cost of Goods Sold refers to costs directly related to the product being sold. Therefore, it does not account for business expenses, simply the cost of the product itself.
Gross profit refers to the profit generated from selling goods or services after subtracting the cost of the product (COGS).
It does not include subtraction of costs unrelated to the production of the item (e.g., interest payments, tax, assets).
Operating profit looks at the profit generated from business activities after subtracting operating expenses from the gross amount.
It does not take into account income from investments or assets as part of the calculation.
Net profit is calculated for a certain period after all costs, including operating, interest payments, tax, etc., are subtracted from the total money earned.
Calculating net profit can be easily done with the help of an income statement, one of the many important financial statements to help you monitor and manage your business.
To help explain profit in a bit more detail, here is an example.
Let’s say you have an international clothing business that operates from the United States. The total revenue generated by your business is $200,000 per month.
|However, you have fixed expenses such as:|
Of course there are additional, variable expenses in a business, but based on the above figures, your net profit would equal $.18,995
Important to note the fees involved in this example. If those can be eliminated or reduced, profit could be above $20,000 a month.
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A question that many have is whether cash flow equals profit for a business.
But actually, cash flow does not mean profit for a business. Instead, positive cash flow is more of an indicator for liquidity and liquid assets.
While cash flow may indicate that a business is profitable, it is not necessarily the same, as profit simply refers to revenue left after subtracting costs.
The truth is, both cash flow and profit are essential to understand financial performance.
Cash flow and profit are two metrics that show a different part of the picture but are equally important to measure and monitor.
Cash flow is useful for measuring liquidity. Profit, on the other hand, indicates earning potential and how a business is performing.
As an example, a business can be profitable but have poor cash flow. Inevitably, the poor cash flow will lead to the business cutting operations down quickly and then going under.
So even though profits are high, without careful monitoring of cash flow and managing possible cash flow problems, businesses can quickly experience financial distress.
That’s why both cash flow and profit need attention and should be monitored regularly to understand business expenses and how revenue is being generated and spent.
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- Investopedia - Cash flow statement
- Investopedia - Gross profit
- Investopedia - Operating profit
- Corporate Finance Institute - Net profit
- Investopedia - Financial Ratios to Spot Companies in Financial Distress
All sources checked 13 October 2021
This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax or other professional advice from Wise Payments Limited or its affiliates. Prior results do not guarantee a similar outcome. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date.
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