The Difference Between Profit and Cash Flow
May 29, 2014
If your boss came up to you right now and asked what the difference between profit and cash flow is, would you be able to respond? Or even worse, what if you were asked this question in a job interview. What would you say? If you are at a loss, don’t worry – most people don’t know there is a difference between the two. But while profit and cash flow may appear to be the same thing, they aren’t, and recognizing how each one impacts the business is extremely important. First, let’s take a look at how both profit and cash flow are recorded. Our bestselling book, Seeing the Big Picture, explains it clearly.
“Cash flow is the difference between actual cash received and actual cash used in the process of doing business (from core operations). Each day, month, quarter, and year, a company receives a certain amount of cash and pays out a certain amount of cash. It’s that simple. Analysts look at cash flow carefully because it’s a very real measure of how a company is doing (whether it will be able to pay its bills tomorrow or next week or next month).
Profit, on the other hand, is revenue from the sale of services and products–whether payment in the form of cash has been received yet or not–minus all expenses–expenses paid in cash, expenses to be paid in cash at a later date, and expenses accounted for in other ways.
While you could say that the profit isn’t 'real' because the cash hasn’t moved in and out of the company, it’s still important to know whether a company is earning income (making more than it’s spending) from its daily operations over a period of time. If we didn’t calculate profit (or income) this way, a company could appear to not earn any income one month, be hugely profitable the next, and so on, depending on when its bills are due and when its customers pay their debts. But that wouldn’t be a very good indicator of how consistently it’s earning income from its core operations, would it? Even if its financial performance was steady overall, it might seem erratic if we didn’t follow this type of accounting system, which is called accrual-basis accounting.
Another way to think of accrual-basis accounting is that it tracks transactions. Sales, expenses, and profits are recorded when the transaction is made. Apple records the sale of a computer when the customer picks it up at the store and the expense for making the computer at the same time, even if the customer arranges to pay for it over several months and the cost of putting the computer together was paid a few months before the sale was ever made. Small companies may use cash-based accounting, in which you record a sale when cash is received and expenses when they are paid.”
TO SUM IT UP
Simply put, profit is generally recorded when the sale is made and cash flow is recorded when the money is actually received.
Now here’s something to think about – can a profitable company go out of business? The answer is YES! Let’s say you own a computer company and are struggling to stay in business when you make a huge sale to Company X with an agreement to get paid in one month. You record the profit now (when the sale is made) but in two weeks, Company X goes out of business and is unable to pay you. Even though you show a profit, you don’t generate the cash you need to sustain the business and may have to close your doors.
You may be asking yourself, “Why should I care?” or “Does it really matter if I know this or not?” (Just don’t ask these questions to your boss). Well now that you know how cash flow and profit are measured, you can start making conscious decisions to improve each of these metrics in your company. If you are in sales, do everything within reason to collect payments sooner rather than later (preferably point of sale). If you are in a position to pay your suppliers slower, do it – though you will want to be careful not to incur any late fees or damage your relationships in the process. Also, anytime you can cut costs or sell more, you are improving your company’s cash flow and profitability.
DO SOMETHING ABOUT IT
This is great and all, but if you don’t do anything about it then you might as well have just watched an episode of Gilligan’s Island. So take a moment to think about the specific ways you can improve cash flow in your company, write down 2 or 3 of these ideas (no, seriously – write them down right now), share them with a colleague or your boss, and then put them to action. And just remember to shoot us a thank you letter when you get a promotion.