When it comes to business financial terminology, it’s easy to confuse cash flow with profit. After all, both terms mean you’re making money, right?
While they are related—and you certainly want both of them to be in positive territory (“in the black”)—they are actually very distinct measures of your small business’s success. And knowing the difference is important to understanding your business’s true financial performance.
What Is the Difference Between Cash Flow and Profit?
Cash flow and profit are both important to a business’s health, but they are unique ways of gauging your performance and looking at your total financial picture.
Cash flow, for instance, is how much money (cash and cash equivalents) your business has available to it at any given time. Measuring your cash flow balance involves subtracting your outflows of cash from your inflows. It gauges how much cash is available to your business at one particular time.
Profit, on the other hand, looks at the total financial gain or loss a business experiences over a more extended period—not simply one moment in time. It measures how much money is left after all expenses are deducted from business revenue.
For example, a small business may be incredibly profitable because, say, it developed a product that it’s selling for a hefty financial gain—such as double the product’s manufacturing cost. However, the business also might be swimming in debt and using every dollar of free cash it has to pay off that debt and cover its expenses. In other words, profits are high, but cash is low.
What Is Profit?
At a basic level, profit is also known as “net income” and is a key metric businesses use to measure their financial success. To calculate it, you simply subtract all expenses from business revenue—and hope you have a surplus. If you don’t, then your business isn’t profitable. (Keep in mind that companies generally pay taxes on their profits—not on their revenue.)
Here’s a simple example: If your monthly revenue is $50,000, and you spend $20,000 to produce that revenue, then your profit for the month is $30,000.
Profitability is an important financial metric because it answers an overarching and quintessential question: Is my business model financially viable? If you’re eking out low profitability, you may need to consider taking steps to improve it, such as raising your prices or reducing your ongoing expenses.
For example, if a product maker is selling its product for $10 and only making $1 in profits after all expenses are paid, it could consider raising its price to $12 or look at ways to lower its production costs.
In order to understand the full extent of their profitability, most companies also use profitability ratios. The most common one is profit margin, which looks at the profitability of a business, product, or service in relation to its overall revenue—and is expressed as a percentage.
In order to calculate your profit margin, you:
- First, calculate your net income (by subtracting total expenses from total revenue).
- Then, divide your net income by your total revenue.
- Finally, multiply the number by 100 (to calculate the percentage).
In the monthly revenue example above, the profit margin is 60%: 30,000 / 50,000 = 0.6, x 100 = 60.
Put simply, your profit margin shows how many cents of profit the business generates for each dollar of revenue. It also allows a business to easily see how its profitability changes over time. For instance, if your profit margin is 10% one year, and 17% the next, your profitability is improving.
What Is Cash Flow?
Cash flow, on the other hand, is how much free cash (or cash equivalents) a business has at any given time, due to how much money is flowing in and out. Unlike profitability—which is purely financial gain on paper—cash flow looks at how much money the business has immediately available and directly affects its spending power. For example, you may have had $100,000 in profits last year, but if only $5,000 of those profits are left, your spending power is far less impressive.
Low cash flow can restrict a profitable business by limiting its options and growth opportunities. For instance, if a business looks to expand and needs to buy new equipment in order to do so, expansion may not be possible if the cash to buy that equipment isn’t available. Low cash also can make a business less financially stable because it may not be able to its pay bills or take advantage of other opportunities that come its way.
Positive cash flow, on the other hand, suggests a business is performing well because it has the cash on hand to easily pay expenses. It also has the financial flexibility to take proactive steps such as paying off debt, building cash reserves for an emergency or economic downturn, or returning money to shareholders. It means the business has the flexibility to take advantage of attractive opportunities instead of being restrained by low liquidity.
Financial experts often consider cash flow a better measure of a small business’s financial performance than profitability because of the flexibility and freedom it affords. When a business has cash, its actions are far less constrained than those of a business with little or no cash.
Because of the importance of cash flow, companies should consider putting together a cash flow statement that details their cash flow status. An important cash flow metric is what’s called free cash flow, or FCF. To calculate your FCF, you:
- First, calculate your operating cash flow (which you can find on your cash flow statement).
- Then, subtract your capital expenditures.
- Finally, subtract your dividends. (Note: Some companies don’t subtract dividends because they are considered discretionary.)
You can learn how to put together a cash flow statement and calculate your operating cash flow by reading our article on how to prepare a cash flow statement.
Keeping Tabs on Both
Profits and cash flow are both instrumental to a small business’s success, so it’s important to understand the differences between them and to use them both as you track your business’s financial performance.
While profitability may be more indicative of a business’s long-term success, cash flow can indicate how well the business is maintaining and spending those profits on a day-to-day basis. Profits won’t help a business if they are not preserved or spent wisely.
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