What is the Difference Between Cash Flows and Profits?

A zoomed in photo of Ben Franklin on a dollar bill, symbolic of the importance of understanding how cash flows and profit are not the same.

Cash flows and profits are financial metrics that are crucial to business success. And people, especially those new to finance and accounting, can confuse the two terms. But cash flow and profit are not synonymous.

You must understand the difference between these terms to run your business successfully. You can jeopardize the financial health of your business if you constantly mix up cash flow with profit.

If you are an investor, understanding cash flows and profits can make it easy to spot a good investment. As a business owner, you can skillfully make crucial decisions and identify growth opportunities.

Let’s find out everything you need to know about cash flows and profits, how they are different, and how they can affect your business.

What is Profit?

Profit is what remains after subtracting all the expenses from revenue. If you are making a profit you are making more money than you need to run your business.

Like cash flow, profit can also be positive or negative. To help you calculate your profit, you need to figure out your total revenues, costs, and total expenses. These three numbers determine whether there is net profit or net loss. (By costs we mean costs of goods sold, or costs of sales. If you don’t know what those are, don’t worry, you can just consider them another expense, or check out this great post on COGS to learn more.)

Subtract your costs and expenses from your revenues. If your profit turns out to be a negative number, your business has sustained a loss. This situation means you are spending more than you are gaining. If the number is positive, you are netting a profit. 

There are three different forms of profit.

  • Gross profit is your revenue minus the cost of products sold, also known as COGS.
  • Operating profit is the net profit generated from your core business operations. It does not include deductions from interest and taxes.
  • Net profit is the amount left after subtracting all operating costs, interests, and tax expenses over a given period. It is the result of deducting your total expenses from your total revenue.

Given this equation, you can deduce that your product price and the costs it takes to produce it are two important components involved in determining your gross profit. 

How you manage your expenses has a considerable impact on the outcome of your business. Evaluate your expenses if your net profit isn’t big enough, or worse, you’re not netting a profit. From there, you can improve your company’s profitability.

Proper pricing could also help increase your profit. You can switch vendors or reduce your employee salary to control your costs, but it is the price that you have total control over. The bigger the difference between your product price and the cost of production, the bigger your gross profit. Find the highest possible price that will not scare off your customers.

What is Cash Flow?

Running a successful business requires you to follow numerous rules. But if there is one rule you must stick to, it would be to never run out of cash. It is extremely important to maintain an adequate cash balance, but unfortunately, many business owners and managers ignore this issue until it is too late.

Cash flow is the net balance of cash going in and out of your business at a given point in time. It can either be positive or negative. Negative cash flows means that your business has more money going out than going in. Positive cash flows suggest that you have more money coming in than going out. Positive cash flow gives you the ability to pay loans, pay expenses, and have a buffer in case of financial challenges in the future.

It is necessary to manage cash flow for daily operating costs, purchases, salaries, and tax payments. You must control cash that moves in and out of your business and know how well your cash balance stands against cash demands. (The statement of cash flows is the financial statement that provides info on the cash that is coming in and out and what it is being used for.)

It’s never safe to assume that cash will always be available as long as you are making a profit. If you don’t monitor and control your cash flow, you may find yourself in a serious bind.

An extremely anxious man squeezing his head, indicative of how not understanding the difference between cash flows and profit can hurt business.
If you don’t understand the difference between profits and cash flows your business might be in serious trouble. Don’t be like this guy!

This is one of the reasons why many product-based startups face money issues. A business that sells products has to spend cash first, whether for buying the product or for getting raw materials. Even if the product has the potential to bring in enormous profits, if the startup does not have enough cash, it will not survive.

​​It can be confusing when you are running out of cash, yet your startup is making money. Experienced business owners will tell you that it’s possible to be making strong profits yet not have enough cash.

This scenario happens because each sale adds to your revenues, and therefore profits (see above); however, sales don’t translate into cash flows until you get paid. So, if you are making sales like crazy and creating products like crazy to satisfy the demand but not getting paid quickly enough you may run out of cash and not be able to pay things like rent and salaries. That is a big problem, to say the least.

With this in mind, “Don’t focus on sales,” is sound advice. Sales are important, but cash is king.

But it’s important to remember that cash flows don’t just come from sales. Cash flows can come from various sources. If you get a loan, that is a source of cash flows. If you sell a piece of equipment, that is a source of cash flows. If you finally get paid on a sale you made a year ago, that is a source of cash flows. If you sell equity to some new investors, wait for it, that is a source of cash flows.

So, in summary, cash flows and profits are not the same thing. Profits are what is left over after you deduct all of your expenses / costs from your revenue, but that doesn’t necessarily translate to cash. Cash flows are a separate phenomenon independent from profits, and represent the actual net amount of cash in and out of the business. To run a successful business you must mind both.

Want to learn more? Check out our handy definitions page here, or, to keep pushing your accounting knowledge to new heights, try this great post on contra accounts. (They’re cool, believe us…)

Who are we? We’re My OC Bookkeeper. Orange County’s premier bookkeeping and business advisory firm. (We also really understand cash flows…) No matter what kind of business you run we can serve as your back office so you can focus on the front. Reach out to us today and let’s do great things together! Watch the video below to learn more.

What Are The Differences Between Cash Accounting and Accrual Accounting?

A professional using a computer and a notepad for accounting work

One of the first decisions a new business needs to make is which accounting method they will use to record their financial transactions. To make this decision one first must know the differences between cash accounting and accrual accounting. (Which are sometimes also referred to as the cash basis and the accrual basis.) Accounting methods are some of the most important, yet most commonly misunderstood principles of accounting, so let’s break them down.

What are the differences between cash accounting and accrual accounting?

The main difference between cash and accrual accounting regards the timing of recording transactions. In cash accounting, financial transactions are recorded once cash is exchanged. In accrual accounting, however, financial transactions are recorded at the time the revenue and/or expense is earned/incurred, regardless of when money is exchanged.

For example, say you operate a landscaping business. In January you mow a lawn for a client, but they don’t pay you for the service until February. In cash accounting, you would wait until you receive the cash in order to record it, meaning you would record the transaction in your February books. In accrual accounting, however, you would record the transaction the moment the service is rendered; You would record the transaction in your January books.

What if the situation is reversed? What if a client pays for a service before you have provided it? The same rules apply in this scenario. Say you were paid to mow the lawn in January, but you didn’t complete the service until February. In cash accounting, you would record the transaction in your January books, because that’s when you received the cash. If you are using the accrual method, you would record the transaction in February, because that’s when the service is completed.

The same is true regarding expenses. In accrual accounting, you record the expense the moment you incur it. Say you buy a new lawn mower in January, but you bought it on credit and don’t need to pay until February. In cash accounting, the expense would be recorded in February, whereas in accrual accounting, the expense is recorded the moment it is incurred, or rather, in January.

The other major difference between cash and accrual accounting is the types of transactions recorded. In the cash method, only the transactions regarding money exchanged are recorded. However, in accrual accounting, you record all transactions related to the business.

What are the benefits and disadvantages of the different methods?

Because there are fewer types of transactions to record, the cash method is much simpler and cheaper than the accrual method. It is easier to maintain and easier to understand. Another advantage of this method is you always know how much cash is available to you at any given moment. However, while the accrual method does require more work, it provides better financial insights and more accurate reports about the long-term health of your company. In cash accounting, you don’t necessarily track your assets, liabilities or equity. Meaning unless you take steps to monitor them, you may have no way of generating reports about your company apart from cash flow. (But don’t worry, we can easily do this for you!)

Another disadvantage of the cash method is it can sometimes lead to false conclusions about your profitability. Let’s go back to our landscaping business example. Here’s an imagined list of revenue/expenses for January and February.

  • January:
    • Billed customers for 5,000 in services completed in January
    • Received payments from customers 1000
    • Purchased new equipment on credit 800
    • Billed by outside contractors 1000
    • Paid outside contractors 700
  • February
    • Received 4,000 in payments from customers
    • Paid credit card bill 800
    • Paid outside contractors 300

Cash Method

JanuaryFebruaryTotal
Revenue100040005000
Expenses70011001800
Profit30029003200

Accrual Method

JanuaryFebruaryTotal
Revenue500005000
Expenses180001800
Profit320003200

These charts, while representing the same transactions over the same period, present two very different scenarios. If you looked at the cash chart, you would think February was your more profitable month. In reality, you didn’t earn any income at all in February, but rather collected payments for services already rendered.

As you can see in this example, the accrual method is a more accurate depiction of how your company is actually performing. Still, there are downsides to the accrual method as well. For example, because you are recording transactions when the services occur as opposed to when the money actually comes in, your books won’t match your bank statements. Additionally, you will be unaware of what your cash situation is. This can be disastrous for a business if you aren’t monitoring your cash flow in other ways. You may end up short on cash without realizing it and be unable to pay your bills, even though the long-term health of your company is stable.

How do the cash and accrual methods affect my taxes?

It’s important to decide early on which method you want to use because the IRS requires individuals and businesses to file their taxes using the same method each year. In other words, once you file one way you have to file the same way each year. Later if you wish you switch methods, you have to file a special request with the IRS.

The method you choose can also have an effect on your year-end taxes. If you use the accrual method, for example, you may end up paying taxes on money you haven’t actually received. For example, if you use the accrual method and you invoice a service in December 2017 for 1,000, but you don’t end up receiving the money until later, the transaction would still be recorded as part of your 2017 taxes. Therefore, another cash method benefit is that you don’t pay taxes on any income until you actually receive the money.

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What method is right for me?

Most individuals and small business use the cash accounting method. This method is much simpler and faster than accrual accounting. If you don’t have a lot of accounts receivable or accounts payable, the cash method may suffice for your business. Especially if you are a business with a lot of cash transactions and are dealing with customers directly, the cash method may be right for you.

If, however, you are a larger business and you don’t get paid quickly, accrual accounting is probably your best option. In fact, the IRS requires certain types of business to use accrual accounting. If your company makes more than five million in revenue, for example, the IRS requires that you use accrual accounting. Additionally, if you are audited, the process will be a lot easier if you use accrual accounting because you have detailed reports about every financial transaction you’ve made.

There you have it, the basic differences between cash accounting and accrual accounting. Still unsure about which method is right for you? Contact us now for a free initial consultation! Want to learn more? Check out our YouTube channel or our blog for all kinds of great accounting, bookkeeping, and business tips.