The Difference Between Profit and Cash Flow

Most company founders don’t understand the difference between profit and cash flow. However, not understanding this distinction could have a disastrous effect on your business.

Not having a firm grasp of both concepts could leave your company without enough cash on hand to pay your bills and push your business towards bankruptcy. Take a closer look at the differences below so you can avoid these issues.

The Basics

Profit is, by definition, the difference between revenue and your operating expenses. It is sometimes referred to as net income. There are three basic types of profit:

• Gross Profit – These are profits based on deducting the direct costs of producing the goods or services your company provides.
• Operating Profit –This profit measure factors in only the net profit from normal business operations and excludes items such as tax payments or interest payments on loans. It also profits from areas outside of the core business. Operating profit is often referred to as earnings before debt and tax.
• Net Profit – These profits deduct all expenses, including taxes and operating costs, such as rent and payroll, from your gross revenue.

Cash flow measures the amount of money moving in and out of your business. It starts with profit and makes adjustments for items that profit fails to take into account. It is a constantly changing figure.

If your cash flow is positive, it’s indicating your business has more cash on hand than it is paying out. If it is negative, your cash flow is indicating your company has more cash moving out.

Flaws with Profit

Profit can be a deceptive measure of your company’s standing and ability to grow. That’s because of standardized accounting rules dictate how various business transactions are recorded.

For example, if you buy a new piece of equipment for your company, accounting rules require you to take the expense in increments. This practice, called depreciation, can make it appear that you have more profit in any given time period than is actually the case.

Why Does Cash Flow Matter?

Cash flow is the lifeblood of your company. You cannot pay for items with the accounting profits that are measured on your books. You cannot buy a piece of equipment or hire another employee without positive cash flow.

Cash flow is the money you have on hand to pay immediate and short-term costs. Without sufficient cash flow, your company may be unable to make a critical purchase, hire staff, or pay bills.

Cash Flow from Operations

Your financial statements will give you a clear indication of how much cash your business has made and how much you have on hand. Looking at the cash flow from the operations section of your financial statements gives you a clear indication of your cash availability.

In this case, cash is actual money the business has made versus profit which is not actual money but an accounting measure.

Differences Between Cash Flow and Profit

Calculating cash flow takes several deft accounting procedures to give you a clear indication of available money. There are a few critical differences that are made when comparing profit to cash flow:

Depreciation

In profit statements, machinery and equipment expenses are recorded in incremental amounts over multiple years. These statements do not match the cash outflows in a given year to make those purchases. With cash flow statements, machinery and equipment purchases are recognized fully in the year in which purchases are made and listed under “investing activities.”

Inventory

In profit statements, inventory is only expensed when it is sold. Inventory that is purchased and remains on-hand to be sold in the future is not factored in. Again, this does not match the actual cash outflows of the business. On a cash flows statement, both: (1) inventory that is sold, and (2) purchased inventory on hand are factored as a cash outflow.

Accounts Receivable

There can be a lag in cash reconciliation on profit statements. The reason? Sales sold on credit are recorded as revenue even if cash has not been collected.

Cash flow statements, however, remove sales sold on credit. They only count cash actually collected from customers.

One of the ways to reduce the lag in cash reconciliation and ensure timely cash collection is to use a Preauthorized Debit service like Rotessa. This ensures that there is little to no lag between when a sale is made and cash collection.

Deferred Revenue

On profit statements, cash received for future product delivery is not recorded as revenue. Instead, it is recorded on the balance sheet, resulting in a mismatch relative to cash inflows.

For Cash Flow statements, cash received for future product delivery is included in cash flow when it’s received.

Is Profit Useless?

While profit can be a confusing and somewhat conceptual figure, it is still important. It is the first item necessary to use in calculating your cash flow. Cash flow, however, goes further by factoring in items that have a real effect on money coming in or going out of your business.

That’s why cash flow is so important in driving growth and success.

Need More Clarification on the Difference Between Profit and Cash Flow?

Are you looking to leverage your knowledge of your company’s financial position? Need help deciphering and interpreting the difference between profit and cash flow?

Schedule a call with Vertical CPA. Our accounting business focuses on startup businesses, providing accounting, tax and virtual CFO services. Let us help you get the most out of your hard-earned dollars.