Business Owners Need to Understand the Difference Between Cash Flows and Profits
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.)
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.
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.)
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