Profit and cash flow are both fundamental for a healthy, growing, and sustainable businesses. However, it’s important to note that they are not the same thing.
Although most accounting mistakes are minor, when unnoticed for periods of time, it can be detrimental to your company’s fiscal health. Understanding the difference between making money versus managing money will be critical to maintaining your business. Growing businesses often face tighter margins and increased expenses—and you won’t find success trying to “out earn” cash problems.
Profit and Cash Flow Are Not The Same
So what exactly is the difference between the two?
Also known as net income, profit is defined as revenue less expenses. In contrast, cash flow refers to the inflows and outflows of cash for a particular business. When small business owners are just starting out, it’s easy to mix the two. Just because you’re earning revenue does not always lead to increased cash. Likewise, incurring an expense does not always decrease cash immediately.
As an example, imagine a web developer who runs an online business designing and building websites for medium to large businesses. To highlight the key differences between profit and cash flow, here are three key focus areas:
1. Revenue Generated
Let’s say a software developer sells a website design for $5,000 on September 1st, and emails an invoice. Their business automatically posts $5,000 in revenue, however the customer doesn’t pay the invoice until September 30th. As you can see, revenue is posted immediately, but the $5,000 in cash is not collected for 30 days.
2. Expense Incurred
On the other hand, the process of designing the prototype and final product cost the developer $4,300 in expenses, including supplies, resources, and hours worked. Because he was busy with other contracts, he may have outsourced a portion of the project to a subcontractor. Whatever the case is, those expenses were paid in July and August, prior to the sale of the website.
Currently, the software business has $4,300 in outflows in July and August before collecting $5,000 on September 30th.
3. Profit Recognized
The profit (P) generated from the newly designed website is:
P = $5,000 – $4,300
P = $700.
This profit is posted on September 1st. It may seem like, in accounting terms, that revenue has already been generated and recognized on September 1st since the sales process is completed when the product (website) is delivered to the customer. However, that $700 profit was not collected until September 30th.
The Difference Between Cash Flow and Profit
Unlike the developer’s lag time in waiting for its receivables, many other companies like Walmart, don’t encounter this issue due to cash being collected at the point of sale. A retailer like Walmart simply receives payments in real-time through cash, debit card and credit card purchases—making cash flow entirely less complicated. If your business uses Square’s enterprise-level payment engine, you have the option to simply integrate your sales data with Kashoo to help improve bookkeeping processes and ultimately, your cash flow.
Cash Flow Management Varies From Business to Business
Keep in mind that the developer had to pay $4,300 in cash to design and deliver the final website to the customer, and earned $700 in profit. At the same time, the developer had a 30 day lag after the sale to recover the $4,300 paid in cash and collect the $700 profit. In the long run, this scenario (of a period of three months) heavily requires on accurate cash flow management and proper budgeting.
Using the previous developer as an example, cash flow can come from sources like:
- Collections on prior sales — cash collections from sales in prior months (May-June) can provide cash to make and deliver website products.
- Delaying cash payments — if the developer needed to outsource various components during the process of designing the website (i.e. say, parts of UX / UI) to another individual or company, the two parties could have an agreement or contract for the developer to pay a deposit for the service, and the rest in 30 days. This delay in upfront payment for design services could put the developer in a much more favourable cash flow position.
- Raising capital — if the developer simply can’t finance his or her cash needs through business cash flow, as a final and least attractive option, the developer could raise capital by issuing stock (meaning an investor can purchase a portion of the company in exchange for cash), or by borrowing funds.
Conclusion: What now?
Growing your small business through consistent profits is highly attractive, but understanding the big picture of the financial needs of your small business requires careful planning. Understanding the differences between profit and cash flow is a key starting point to grow your business without having to resort to raising capital.
Once you understand the difference between the two, see how TrulySmall Accounting can help manage your cash flow needs (income and expenses) to gather an accurate, overall picture of your business finances. Try our 14-day free trial today to see how we can help!