Cash flow and profit are critical metrics that can reveal a company’s financial health. Companies can review cash flow and profits to ensure they won’t lose money on orders or take on too much business at a given time.
While cash flow and profits serve the same objective, they are not the same. Knowing the difference between cash flow and profit will indicate the true nature of a company’s financial status and lead to better decisions.
What Is Cash Flow?
Cash flow tracks a company’s cash inflows and outflows. A company with net inflows generates positive cash flow, while net outflows indicate negative cash flow.
Businesses can survive on short-term negative cash flow that aligns with investments and requires that you wait for invoice payments to arise. However, all thriving businesses produce long-term positive cash flow.
Companies that always yield negative cash flow are not sustainable and they cannot properly function unless investors pour money into them. Too much negative cash flow can force companies to take out loans to cover expenses, and that can be a difficult cycle to break.
Loans increase your cash flow, but you’ll have to pay them back with interest in the future. Improving business cash flow makes you less reliant on loans and other forms of leverage.
What Is Profit?
Profit reflects the proceeds that a business keeps after accounting for expenses. Profitable companies make more money than they spend and they can continue scaling, while unprofitable businesses spend more money than they make and find it difficult to scale.
An unprofitable quarter won’t shut down most businesses, but an unprofitable model is unsustainable and, over time, it could result in the closure of these businesses. Furthermore, business owners have two ways of calculating profits.
- Gross Profit: Gross profit is the difference between revenue and the costs of goods that are sold. If a business sells a unit for $80 and the product costs $20 to make, the company yields a gross profit of $60 per sale.
- Net Profit: Net profit is the difference between revenue and all business-related expenses. It covers a wider scope and it is a more accurate indicator of the financial health of a company. Saving money and using your resources smartly will improve your net profit.
Is Profit More Important Than Cash Flow?
Profit and cash flow are both important metrics for any company. Profitability is more important in the long term and it indicates whether or not a company is sustainable. A profitable business has an easier time generating positive cash flow as well.
However, cash flow is more important in the short term since cash outflows fund investments, wages and other expenses that help your company grow. Negative cash flow can feel restrictive, especially because it can slow down your business eventually.
Does Positive Cash Flow Mean a Business Is Profitable?
Positive cash flow does not always indicate a profitable business. Loans are cash inflows that initially help generate positive cash flow, and some people borrow money to keep their businesses alive.
Loan payments come later and make it more difficult to achieve positive cash flow. You also may receive an invoice payment from an invoice you obtained several months ago.
That invoice will help with current cash flow but not with profitability. Incoming invoice payments from months past without a steady stream of new customers can result in positive cash flow but an unprofitable business.
How Can a Company Have Profits but No Cash?
Unpaid invoices count as profit when you send them to clients. However, you will not receive cash from these invoices right away.
This delay can result in a profitable company without cash. These invoices will eventually get paid as you perform services and wait for the client to pay, but businesses will have to manage with the capital they have while waiting for those invoice payments.
Some companies use invoice factoring or take out loans to accumulate inflows while waiting for invoices to get paid.
Comparing Cash Flow & Profit
Understanding what counts as cash flow and profit will help you record each transaction and make the right decisions for your business.
Revenue gets posted immediately upon sending an invoice to a client. Business owners count all of those proceeds as revenue under the current period.
However, the cash flow from that invoice will come gradually. You may have to wait several months to see those profits materialize as cash flow depending on the invoice’s length and terms.
Rising operational costs will hurt your profitability and increase your cash outflows. Having more cash flowing out of your business without enough inflowing cash to compensate will also decrease your cash flow.
Some companies have cash reserves to navigate rising operational costs, but you will either need higher revenue or lower expenses to maintain strong cash flow in the future.
Overspending increases your costs at a faster pace than revenue growth. This predicament will negatively impact your profit and hurt cash flow.
Spending money requires cash outflows which makes it more challenging to maintain positive cash flow. Overspending also results in the misallocation of dollars. You may have to forgo cash outflows for more important expenses to compensate for overspending.
Preserving Your Finances
Profitability and cash flow allow businesses to continue operating and expand their market share. These two very vital metrics will determine how much you can spend on investments as well as how much money you’ll have left over after covering all of your business expenses. Preserving your finances will put you in a better position to serve customers and create new jobs.