Don’t be fooled into thinking that cash flow and profit are the same thing. In fact, there are major differences. Cash flow is dynamic and moves daily, while profit is a snapshot of income and expenses at a specific point in time. Understanding this comparison, and acting upon it, can be significant for a small-business operation.
Background: Essentially, cash flow represents the difference in cash on hand from the beginning of an accounting period to the end. While cash comes “in” from sales, loan proceeds and investments, it also goes “out” to pay operating expenses, loans and asset acquisition. This can be reflected in a cash flow forecast.
Conversely, profit is the amount left over after business expenses have been paid. It is reflected on a profit and loss (P&L) statement.
Assuming you are using the cash method of accounting, you might have a relatively good handle on cash flow. But are you actually turning a profit? You could operate for long stretches without knowing the answer. Conversely, if your entire focus is on profit, as shown in the P&L statement, you might run out of cash when you need it the most. Let’s take a closer look.
The cash flow forecast records only actual cash transactions. It may be affected by a capital contribution by the business owners or investors, or the sale of assets. Although these events increase cash flow, they do not result in more profit. Reason: Income is not being generated from normal business activity. It is possible to be suffering a loss even if you have plenty of cash in the business account.
Similarly, if you buy expensive equipment or extensive inventory during the year, without enough sales, you could be showing a profit but still be in a dangerous cash flow position. Unlike a cash flow forecast, the P&L statement includes adjustments other than cash transactions. This includes the following items:
• depreciation expenses on capital assets such as equipment
• debts written down (e.g., on an uncollectible account receivable owed by a customer or client)
• assets sold at a loss or profit
• buildup of inventory
If you are not careful, you can easily confuse being busy with being profitable, especially when your business is starting out. Remember that your profit is the amount left after all costs have been deducted. If you have not calculated sales prices correctly, a thriving business may, in fact, be operating at a loss. Despite a favorable cash flow, the P&L statement depicts a more accurate picture.
In other words, do not set prices without factoring in all the costs. Otherwise, you may end up operating at a loss or at a small profit level that cannot be sustained over time.
In conclusion: This is only a brief overview, and there could be other complications. For example, timing is often an issue, or the accrual method of accounting is being used. Rely on your business advisers for assistance.