A lot of words get thrown around talking about small businesses. Cash flow and profit may seem similar, but they’re different. Our content partner Nav.com has answers!
According to a Quickbooks report from earlier this year, “61% of small businesses regularly struggle with cash flow”.
Even if your business is profitable, you can be at risk of falling into financial demise. How? Because if you don’t have enough liquid cash on hand to meet the myriad of current and near-term expenses that come with owning a small business, it can nearly impossible to keep your operation afloat.
What is cash flow?
Cash flow is essentially the cycle of funds going in and out of your business from operations, investing, and financing activities. It’s the amount of liquid cash that you have at your disposal at a given time. Your business can either be cash flow positive, or cash flow negative.
Positive cash flow is when cash inflows are greater than your cash outflows.
Negative cash flow is when your cash outflows are greater than your cash inflows.
Examples of cash inflows are money coming in from accounts receivable, the sales of services and products, and borrowed capital like lines of credit or term loans.
Examples of cash outflows are money going out for accounts payable, payroll, taxes, rent, loan payments, and other expenses.
If you decided to borrow $75,000 to cover equipment financing, the lump sum of capital you receive upfront would be considered cash inflows, and your payments on the loan would be considered cash outflows.
What is profit?
Profit (also known as “net profit” or “net income”) is the amount of money that remains after all expenses — including costs of goods sold (COGS), as well as operating costs, interest payments, loan payments, and taxes — are deducted from your revenue.
To figure out your total profitability, you need to understand both gross profit and net profit.
Let’s say you own a flower shop. You bring in $25,000 of revenue in April, but your COGS (i.e. wholesale flowers) amount to $10,000. Your gross profit would be $15,000.
Revenue – Cost of Goods Sold (COGS) = Gross Profit
$25,000 – $10,000 = $15,000
Your gross profit is what you make from selling flowers, but it does not account for all the other operating expenses that are involved in running your flower shop, such as the cost of rent, electricity, payroll and advertising. Factoring in your operating expenses, your net profit for April would be $10,000.
Gross Profit – Operating Expenses = Net Income
$15,000 – $5,000 = $10,000
While profitability provides you with a snapshot of your financial situation during a specific accounting period, it fails to account for the day-to-day stability of your operation.
What’s the difference?
While being cash flow positive and profitable may seem pretty much the same at first glance, there’s a significant difference that is important to understand.
To operate, you need cash on hand to meet payroll, make rent and insurance payments, and handle the laundry list of other day-to-day expenses to keep business running as usual.
Many businesses use the accrual method of accounting, which records income and expenses when you earn or incur them — regardless of whether the cash has actually been exchanged.
If you’re sending out invoices to clients that may not be paid for 30, 60, 90 or even 120 days, your real-time cash flow situation will look very different than your profitability — and you may find yourself without enough liquidity to keep your business running.
Let’s use a single invoice to illustrate this point. You land a huge opportunity with a wedding planner, who needs $15,000 worth of arrangements for an upcoming wedding. You invoice the customer on May 1 with a deadline of 60 days. You also have to pay your vendor $8,000 for the supplies (flowers) within the next 30 days.
Without factoring in your operating expenses for this transaction, your next income for May would look like $7,000 — not bad at all!
But this fails to give you a clear picture of your cash flow. That’s where the cash basis of accounting comes in. While used less commonly, it is important for gauging how much cash you actually have on hand, as revenue and expenses aren’t actually recorded until the money is exchanged. With terms of NET60, you wouldn’t actually receive the money until July 1. See below:
This is a simplified example with a single invoice. If you’re sending out multiple invoices with different payment terms and managing the day-to-day operational expenses, you can see how staying out of the red could get tricky.
That’s why it’s so crucial to not only understand the difference between cash flow and profit, but figure out better ways to increase your cash flow.
This article originally appeared on Nav.com and was re-purposed with their permission.
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