Aug 20, 2021How Profit and Cash Aren’t Actually The Same Thing
What Are the Differences Between Profit and Cash Flow?
Profit and cash flow are two important terms in the financial world, and while they may seem to be referring to the same thing, they are distinct measurements of a company’s financial health. Since a proper understanding of both profit and cash flow are essential to securing the financial success of any business, this article provides an overview of their key differences as well as other general considerations.
What Is Profit?
Profit refers to the amount of money left over after expenses have been subtracted from a company’s proceeds or revenue. Any business will have a variety of expenses that must be taken into consideration before calculating the final profit or net profit. There are three main types of profit:
- Gross profit is calculated by subtracting the cost of goods—the cost of materials and labor—from the revenue.
- Operating profit is the net profit made through normal business operations or the principal business earnings before interest and tax (EBIT) payments.
- Net Profit is the final profit remaining after all other expenses have been deducted.
Businesses record profit on an income statement, which is also known as a profit and loss (P&L) statement. The income statement summarizes all the earnings and expenses during a specific time frame, and these records are usually updated and reported both quarterly and annually. Along with other financial documents, the income statement provides an important piece of the puzzle that allows for an accurate understanding of a company’s financial health.
What Is Cash Flow?
Where profit represents the net income of a business, cash flow refers to the cash that is moving in and out of a business. When businesses spend money on purchases, supplies, and other expenses, this is an outgoing cash flow. When businesses receive money for the purchase of their products or use of their services, this is an incoming cash flow. This constant movement of funds is one of the biggest differences between profit and cash flow, as cash flow is both incoming and outgoing, but profit is calculated only from the incoming cash. Cash is also used to service debt, fund asset purchases, and pay off employer tax liabilities. Although none of these items appear on the P&L, they still require cash.
If a business has more money coming in than going out, this is a positive cash flow. Similarly, if more money is going out than coming back in, this is a negative cash flow. Over time, consistent negative cash flow will require the business to seek additional sources of funding through loans, investors, and credit card debt. Eventually, these debts must be paid off. So, when the business eventually experiences positive cash flows, these excess funds will be applied to existing debt. Cash is the lifeblood of any business. If your business isn’t profitable, eventually it will show up in your cash flow.
The following categories are three different categories of cash flow:
- Operating cash flow or the cash made through normal business operations.
- Investing cash flow or the cash made through investments.
- Financing cash flow or the cash used to finance normal business operations.
These three categories of cash flow appear on the cash flow statement. Businesses use the cash flow statement to report their company’s incoming and outgoing cash during a certain time frame. This document should include detailed information on all transactions completed during the chosen time frame. The organization and details put into this report will lend to an accurate depiction of a company’s financial health.
How Can Understanding Profit and Cash Flow Measure Success?
When it comes to measuring the financial health of a business, both profit and cash flow should be taken into consideration. Valuing one above the other does not take into account how these two financial measurements are connected.
For example, a company’s cash flow may be very active and seemingly healthy, with regular incoming and outgoing cash. However, if there is no profit for a period of time, this will eventually have a negative impact on cash flow. Cash flow without profit is not sustainable long term.
On the other hand, a company may have profits while having funds tied up in assets or investments. Although purchasing assets and investments does not affect profitability generally, it could have an effect if there is no ROI or if they aren’t performing. These examples demonstrate that both profit and cash flow need to be positively maintained for a business to achieve financial success.
Ultimately, businesses should analyze their current financial circumstances and keep accurate records to determine how to continually improve their financial health.