Have you ever checked your bank balance and found that it is alarmingly low, and yet your financial statements are still showing a profit? This is a point of frustration and confusion for many business owners . To solve this mystery, you need to understand the difference between cash flow and profit. This article will help you understand what is happening so you won’t be caught off guard by this issue.
What are Cash Flow and Profit?
We can think of profit as the score of your business after you pay all your bills (it’s a theoretical score).
Profit is what your business earns when you claim your expenses according to the rules of accounting and tax. If you are a cash basis tax payer, this the “Net Profit” on your profit and loss statement.
Meanwhile, we can think of cash flow as all of the actual cash that flows into and out of your business. It is the flowing oxygen of your daily operations. Cash flows out to pay your employees, your suppliers, and your overhead.
Why do they differ?
Loan principal payment, payroll, and sales tax liabilities:
Let’s first talk about expenses that affect your cash but does not affect your profit. Lets say you repay your bank loan. When you make your loan principal repayment it feels like it is an expense, but it does not affect your profit; you just transfer the money from your bank to your debt balance. That is why your profit report may be looking good but your cash balance does not align with that profit optimism. Investing in inventory is also a great example. When you have inventory, you cannot recognize the cost of inventory you have purchased on your profit and loss up until you sell the item.
Another difference is that small businesses expense certain things at different times relative to the rules of tax and accounting. Something like credit card expenses is a good example. The IRS allows you to deduct credit expenses on the day you charged the card; however, the credit card bill will not come due for 25-50 days. If you carry a balance, you will hold onto that cash much longer, but with severe penalties from the additional interest the credit card company charges.
Owner Withdrawals and Cash Flow
For small business owners, the amount of net profit is important since it represents your taxable income. Your net profit does not take into account the cash you may need to keep for income taxes, and if you do not properly plan ahead, your cash flow can be hit suddenly; you need to keep that cash available for that liability.
Financing Business Assets
This can also work in the other direction, where your profit is less than your cash flow for the year. For example, let’s say you purchased a new vehicle or upgraded your equipment on a business credit card or a loan. For that year a purchase is made, particularly if you can expense the entire cost, your taxable income is very much reduced. On the other hand, to the extent that the financial institution is paying the buy price on your behalf the immediacy of your cash flow did not stop at the same time as your income did. Your cash outflow will be gradual, as you pay for the equipment in taking years to pay out.
Practical implications for making business decisions
Having established this distinction, let us now consider how cash flow and profit are different yet work together to help make business decisions, and why they both really matter too.
The role of cash flow with operating stability
Cash flow is really critical for the day-to-day operating stability of your business. Cash flow is the cash you have available to pay the bills, buy stock, and emergency costs. If you have cash flow you can pay your bills on time and actively avoid additional debt. Even if your business is profitable on the books, if you have negative cash flow, there is not going to be any real immediate trouble. So while there may be a profit number at the end of the month, if there is no cash coming into your business when you pay the loan payments and stock the shelves, you will still have a lot of cash stress.
The strategic role of business profit
Profit is the fuel that makes your business grow over a long time. Sometimes referred to the sustainability of your business model over the course of the long term. Profit drives long-term strategic decisions like business expansion and/or investment for new strategic projects, and adding appetite for growth.
Understanding and managing both cash flow and profit are the keys to making informed, strategic business decisions. Profit suggests businesses overall health and growth potential while cash flow visually assists with real-time management of your cash runway. Ignoring either cash flow or profit will lead to financial mistakes which put your hard-earned finances at risk.
Conclusion
Today we were able to disentangle cash flow from profit, to show you how each plays an important yet different role in the health of your business. Now it’s your turn to examine your own business cash flow and profit, consider what to change, and how they work together.
Final Thought
Do not forget, you can still be profitable and run out of cash, learning how to manage cash flow and profit will enable your business to not only survive but also thrive. Our team of bookkeepers and tax accountants can help you with keeping track of your business profits and anticipate your cash flow and your overall tax planning. Click here to book a free discovery call or meeting. Keep both eyes on your business: when one eye is on cash flow, and the other is on profit, and you will be able to manage your business finances with confidence.