Cash Flow vs Profit: What’s the Difference and Which is More Important?

It’s the age-old debate: cash flow or profit? The two are related. But they are not the same thing, and business owners often need to sacrifice one in the short term. In the long term, a business needs both positive cash flow and profits to continue trading. But which one should entrepreneurs prioritise? Some say that “cash is king” whilst others argue that “profit is everything,” but what is the truth? Let’s take a closer look and find out.

What is Cash Flow?

Cash flow is the money flowing in and out of a business. It refers to available funds rather than money tied up in uncollected profits or hard assets. A business needs cash to continue operations. Without cash, the owner cannot pay suppliers, staff, and utility bills. Or buy inventory. If your business was a car, then cash flow would be the fuel in the tank – you can’t move forward without it.

There are three main types of cash flow:

  • Operating cash flow. The amount of cash generated from regular business operations, such as sales.
  • Investing cash flow. Cash earned from investments, such as securities, property, or the sale of assets. During a period when your business is investing, this number may be negative. But it will become positive when these investments begin to generate a return.
  • Financing cash flow. The net cash generated to finance the company, including debt and dividend payments.

Positive cash flow means that more cash is coming in than going out. Your business’ liquid assets are increasing. Negative cash flow means the opposite.

It’s normal to experience a short period of negative cash flow when you are investing in growth. This happens because you must first spend money to generate more liquid assets in the future. But, a sustained period of negative cash flow means that your business is running out of fuel. When this happens you need to take action.

What is Profit?

In a nutshell, profit = revenue – expenses. It’s how much money remains in your business after you deduct expenses from your total turnover. Again, there are three main types of profit:

  • Gross profit = revenue – cost of goods sold. This includes variable costs such as materials and labour, but not fixed costs such as rent.
  • Operating profit = revenue – business costs. This figure includes fixed costs but excludes tax, interest payments on debt, and income from investments. These are outside the realm of the core business.
  • Net profit = revenue – all expenses, including tax and interest.

It’s important to understand the difference between these three figures. This will help you understand which costs have the biggest impact on your net profit.

Which is More Important?

Both cash flow and profit are important to the long-term success of a business. But in the short term, it may be prudent to prioritise one over the other. It’s possible to be in profit and yet run out of cash, and vice versa. Both matter, but which matters most depends on your current financial situation.

For example, a business may make a profit each month. But if that money is tied up in assets then it may be unable to pay employees and suppliers. In this situation, it will have to stop trading. In this instance, the business should prioritise cash flow.

But, a business may have a healthy cash flow but fail to make a profit due to excessive debt. Here, it may be prudent to prioritise paying off to order to become profitable.

Failing to generate a profit over a sustained period of time will harm cash flow. It’s important to balance cash flow and profit. But this can be difficult to do – especially when you’re a busy business owner with a lot on your plate. For this reason, it’s worth investing in a qualified accountant. He or she will help you to maintain a healthy cash flow whilst generating a profit without losing your mind in the process.

4 Common Cash Flow Mistakes Small Business Owners Make

Cash Flow Chart on Desk

Good cash flow is essential to the financial health of your business. In finance terms, cash is comparable to food. Without it, your business will run into many health problems and may even starve. Cash flow problems are one of the main reasons that small businesses fail. So you need to make this a priority.

This list of common cash flow mistakes will help keep your company in good financial health.

1. Unrealistic Budgeting

Many small business owners underestimate how much it costs to get started. This can lead to an array of cash flow problems. If in doubt, always overestimate your costs to avoid any nasty surprises.

If you don’t know how long it will take for your business to make a profit, you may face some serious cash flow problems. It’s important to create a realistic time frame for your business to reach profitability. Remember to account for seasonal peaks and troughs, too.

Many small business owners delay hiring an accountant until after they launch. But working with an experienced accountant will help you to create a realistic budget. This will save you a significant amount of time and money in the long run.

2. Not Creating a Cash Flow Budget

As well as a business budget, you should create a separate cash flow budget. You need to understand when money will be flowing in and out of your bank account and be able to plan ahead. Money tied up in unpaid invoices is no good to you when your suppliers need payment right now. You must always have enough cash to continue operations, so creating a cash flow budget is vital.

3. Slow Invoicing

One of the simplest ways to ensure a healthy cash flow is to get paid on time. Of course, this isn’t always 100% within your control. But there are plenty of things you can do to encourage your clients and customers to pay you faster.

First, when onboarding a new client, spell out payment details straight away. Then everyone knows what to expect. You should both understand:

  • Who will handle the invoice
  • When will it be sent
  • What are the payment terms
  • The method of payment.

It’s also worth checking who you should contact to handle any potential problems that may arise.

Second, send invoices on time and ensure that all the details are correct. This will prevent a time-consuming back-and-forth communication to straighten out any mistakes.

Finally, keep a close eye on deadlines. And don’t be afraid to send out a polite but firm reminder to customers who are cutting it fine. You may also want to consider introducing a late payment charge to incentivise them to cough up on time. But be sure to give your customers plenty of notice.

4. Not Having a Cash Reserve

Having a cash reserve is imperative for good cash flow management. But many business owners skip this crucial step and then find themselves in hot water later on. All businesses will experience unforeseen costs. And it’s important to prepare for this by creating a cash reserve. This way, you can smooth over any cash flow issues without going into debt. or suffering an extreme amount of stress.

Summary

Maintaining a healthy cash flow is one of the most difficult parts of running a business. But it’s also important to the financial health of your company. Plan ahead, and create a realistic budget to help you avoid overspending. Remember, cash flow and profitability are not the same thing. So it’s prudent to create and track a separate cash flow budget, too. You can’t overstate the importance of good cash flow management. So when in doubt it’s always best to defer to a quality accountant for help with this essential process.