Cash flow and profit are key financial factors that can help you determine the financial performance of your company. These two factors make it easier to assess whether the goals or objectives of your company align with its current financial performance. Understanding the differences between cash flow and profit can help you determine if your company needs to adjust its operating or sales strategies. In this article, we explore the differences between cash flow and profit and provide different examples for each.
What is cash flow?
Cash flow is the course of funds going in and out of a business. There are various financial activities that affect cash flow, such as operational expenses, investments and other financing activities. Cash flows can be positive or negative based on the inflows and outflows of an organization. Here is a more detailed review of the two different types of cash flows:
- Positive cash flow: This type of cash flow occurs when a company’s cash inflows are greater than their cash outflows or when the amount of liquid cash exceeds a company’s expenses.
- Negative cash flow: This type of cash flow occurs when a company’s cash outflows are greater than their cash inflows or when a company’s expenses exceed their liquid cash on hand.
What is profit?
Profit, otherwise known as net income, is the amount of money that remains after a company accounts for all expenses. These expenses include operational costs, interest payments, taxes and loan payments. There are three major types of profit that companies analyze:
- Gross profit: This is the profit a company makes after accounting for costs associated with making and selling its products or providing its services.
- Operating profit: This profit type is a company’s total earnings from its foundational business functions for a set period and doesn’t account for interest or taxes.
- Net profit: This is the profit a company makes after it deducts all expenses from earnings.
Cash flow vs. profit
While cash flow and profit interact with each other in accounting, there are several important differences between these two terms, including:
Business function
Cash flow is essential to the daily operation of your company. It enables you to pay immediate expenses such as electricity, water, payroll and other operational costs. It also allows you to pay invoices for supplies and equipment to operate your business.
Profit affects your business’ functionality after a longer period than the daily and weekly functions of cash flow. Your company’s profits should exceed its expenditures over a time period, such as three or six months, to remain in business. Some items that affect your company’s profit include variable operating expenses and customer demand.
Importance of time
Cash flow and profit are both essential to the success of your business, however, the importance for each is different in relation to time. Cash flow has short-term importance, as it’s a factor in your daily, weekly and monthly decisions. Profit has a long-term importance because it measures the comprehensive earnings of your company.
Forecasting ability
Cash flow and profit can help you identify trends for your company. However, they help pinpoint slightly different aspects of your company’s financial performance. Cash flow can communicate the trends for positive and negative cash flows. This can help you make the financial choices that ensure you have funds to pay your immediate expenses on time.
Profit can indicate sales and overall expenses trends to help you align your business objectives with actual performance. For example, analyzing your profit performance can help you determine if your company has seasonal trends. Seasonal trends can affect your company’s financial performance during periods that your products or services aren’t trending.
Basis of accounting
Cash flow uses the cash method of accounting, because it recognizes when your company collects the actual cash from the sale. It also records when your company physically settles its liability, otherwise known as an outflow. The accrual method of accounting doesn’t reflect your company’s cash flow. This is because it recognizes a sale when your company performs the sale, regardless of when the customer pays the amount due. Additionally, it recognizes an expense when it occurs instead of recording the liability as your company pays the expense.
The accrual method of accounting can help your company track its monthly profitability because it records income and expenses as they occur. This is useful in forecasting profits if your company issues customers’ credit that they can pay back over a period. The cash method of accounting can also be used to help your company determine profits as long as you don’t issue credits on customer accounts.
Examples of cash flow and profit
Here are three examples about cash flow and profit:
Positive cash flow example
April’s Garden has a large order of flowers to deliver on June 15. On June 13, they pay a vendor $8,000 to have the flowers for the order delivered to the shop. April’s Garden currently has a net cash flow of -$8,000. When they deliver the flowers on June 15, the customer pays $12,000 for the delivery. After the payment, the net cash flow of April’s Garden is $4,000.
Negative cash flow example
Danny’s BBQ has a catering order to deliver on July 15, but before that date, he must purchase the ingredients to make the order. The supplies cost $3,000, which Danny’s BBQ pays once they receive the supply order. The $3,000 cash outflow means the current net cash flow is -$3,000. When they deliver the catering order on July 15, the customer only pays $2,000, which is half the order invoice. The cash inflow doesn’t fully cover the company’s current cash outflow, so after the payment, the net cash flow of Danny’s BBQ is -$1,000.
Profit example
On March 31, Jude’s Pizza reports a quarterly revenue of $20,000. The company’s overall expenses for the quarter amounted to $13,000. To calculate the quarterly profit, the company’s accountant subtracted the business’ revenue from its expenses to get $7,000. This means the total profit for the quarter was $7,000.
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