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.

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.

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.)


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.

Basic Bookkeeping Categories

Bags filled with different colored beans symbolic of the categories bookkeepers use.

Bookkeeping Categories

Bookkeepers do more than simply keep track of profits and losses. They record every financial transaction related to an entity.  It is only with these records that business owners and accountants can analyze the overall well being of a company. Because there is so much varied activity related to a business on any given day, staying organized is paramount to a company’s success, and subsequently, one of a bookkeeper’s most important roles. How do they do it? With bookkeeping categories, that’s how.

All bookkeepers use the same five bookkeeping categories to keep transactions organized. Because all bookkeepers use these same designations, it creates a universal language wherein anyone who understands bookkeeping can judge the financial health of a company. Each category is important for understanding the financial picture of a company.

Profit & Loss Account

The five categories bookkeepers use are assets, liabilities, equity, income, and expenses. These five categories are then divided in two accounts. One of these accounts is called a profit/loss account (also known as a income statement). This account tracks the total amount of revenue coming in versus going out, or in other words, how much money you are making. (Things get a little more confusing with accrual accounting, but most small businesses use cash accounting.) It is made up of income and expenses. Income refers to any revenue coming into the business. This can include product sales, services, consulting income, etc. Expenses refer to the things you pay for in order to keep the business running. This includes payroll, rent, utilities, or any other overhead expense. The purpose of a profit/loss account is to determine your net income (profits). In order to achieve this, you simply subtract your overall expenses from your overall income.

 

Income               –Expenses                            =Net Income
Examples:

product sales, services, consulting income etc.

Examples:

payroll, rent, utilities

Total profits

Balance Sheet Account

Just because your income statement says you’re making lots of money doesn’t necessarily mean that your company is stable.  This is why you also need the three remaining categories. They can tell you a lot about the financial health of your company. These remaining categories are assets, liabilities, and equity. They are grouped into what’s known as your balance sheet account. Your assets are everything you OWN or have the rights to. Some examples you would file into the assets category include bank accounts, cash, accounts receivable (what customers owe you), inventory, and equipment, just to name a few. Your liabilities are the things that you OWE. This would include accounts payable (unpaid bills), credit cards, loans, sales tax payable, etc. Finally, your equity is what the business is worth in a given moment in time. This would include your capital investment (your original investment), retained earnings (remaining profits), and shareholder contributions. When you add your total liabilities to your total equity, it should equal your total assets. This is why it’s called a “balance” sheet account.

 

Liabilities      +Equity           =Assets
Examples: accounts payable, credit cards, loans, sales tax payableExamples: capital investment, retained earnings, shareholder contributionsExamples: banks accounts, cash, accounts relievable, inventory, equipment

 

Asset Liability Ratios

The best and easiest way to determine the financial health of your business is through your balance sheet account. A healthy business has a 2:1 ratio of current assets to current liabilities. Your current assets are assets that will be converted into cash within the next 12 months. Similarly, current liabilities are bills that are due within twelve months. For example, if your current assets total $20,000, and your current liabilities are $10,000, you have a healthy business. If you have a higher ratio, say 3:1 or even 10:1, it may be time to consider investing, or time to pay off loans with your excess capital. If you ratio is less than 2:1, you need to make changes in order to protect your company.

In summary, individuals and business need documentation of every single transaction in order to have a complete understanding of where they stand financially. However, this quickly amounts to an enormous amount of information. In order to save time, bookkeepers organize each transaction into specific categories. With this information in tow, business and individuals are able to make confident and informed decisions about the future of their enterprise.

There you have it. My OC Bookkeeper’s introduction to the most basic bookkeeping categories. Check out our introduction to balance sheets to learn a bit more about balance sheets, and check out our introduction to income statements to learn a bit more about income statements. Or, Investopedia is a great place to learn about all things business, finance, and accounting. And of course, remember to reach out to My OC Bookkeeper – Orange County’s best small business bookkeeping company for all of your bookkeeping and tax needs.

Like videos? Here is a great educational video on bookkeeping categories – for other great accounting videos check out our YouTube channel.