The difference between profit and cash flow
/What is Profit?
Profit is the financial gain a business makes when its revenue exceeds its expenses. It is calculated by subtracting total costs from total income. Profit can be categorized into gross profit, operating profit, and net profit, each representing different levels of earnings. A consistent profit indicates a healthy business, while losses may signal financial trouble.
What is Cash Flow?
Cash flow is the movement of money into and out of a business over a specific period. It consists of cash inflows from sales, investments, or financing and cash outflows for expenses, operations, and debt payments. Positive cash flow means a company has more money coming in than going out, while negative cash flow indicates financial strain. Managing cash flow effectively is crucial for a business to meet its obligations and sustain growth.
Comparing Profit and Cash Flow
There are several differences between profit and cash flow, which are as follows:
Timing difference - sales. A business sells goods to a customer and issues it an invoice, which the customer pays 30 days later. This is a timing difference, where the business records revenue as soon as it ships the goods, but it does not record the related cash inflow until 30 days later.
Timing difference - expenses. A business buys goods from a supplier, under payment terms that require it to pay the bill in 30 days. The business puts the goods in its warehouse and sells them to a customer 10 days later, at which point it is charged to expense. This is a timing difference again, where the business records an expense before it experiences a cash outflow when it pays the supplier.
As you can see from these two timing differences, a company’s profit and cash flow would only be the same by coincidence. Nearly all the time, the two figures will be different, depending on when a company recognizes revenues and expenses, and when it pays suppliers and receives cash from customers.
There are several other issues that impact cash flows but have only a modest impact on profits. They are as follows:
Purchases of fixed assets. A company incurs a large cash outflow when it buys a fixed asset, but the related expense is only recognized over a long time, in the form of depreciation. Thus, a large fixed asset purchase could result in deeply negative cash flows, while the business reports a monthly profit because its related depreciation expense has only increased by a small amount.
Fund raising activities. A business may engage in fund raising, either from taking on debt or selling shares to investors. In either case, the company records a large cash inflow, irrespective of its underlying level of business activity.
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When More Sales Cause Cash Flow Problems
Yet another issue impacting cash flows is rapidly increasing sales. A major problem for rapidly-growing firms is that they extend credit to customers, which delays cash receipts, while having to pay suppliers at a more rapid clip. The result is businesses that report increasing profits while their cash flows turn deeply negative. A business needs to track its cash flows in great detail to keep from running out of cash in this situation. It is quite likely that cash flow problems will force the firm to curtail its rate of growth, or to take on new investors to fund the growth - which waters down the ownership interests of the company founders.
In short, managers need to understand that profits do not equate to cash flows, and that a business can report robust profits while running out of cash at the same time.
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