Cash flow and profit are crucial metrics for keeping track of your income. But the two are not synonymous. One is intended to help drive careful business decisions whilst the other is rooted in sales and targets.
Getting profit and cash flow confused can have catastrophic and irreversible consequences so it’s important to get it right.
What is the difference?
What are cash flow and profit used to measure?
Cash flow gives an up to the minute, accurate account of how much money is in your business. It only takes into account money that has been paid. You might have recently brought in a £800,000 project, which is great for profitability, but that’s no good if the supplier isn’t paying up and your business is sitting in the red. So, if a sale has been agreed and a contract signed, but no money has been transferred, it will not count towards cash flow. Cash flow reports can be used to navigate a business’s way through peak expense periods and determine when it’s safe to make investments.
Profit, on the other hand, is used to establish if the value of sales coming in is enough to sustainably drive the business forward. A profitability report would take into account the aforementioned sale because it is money that will eventually be transferred. Most businesses will set a profit target based on reports from the previous year.
Not all transactions count towards profitability
Here’s the thing – cash flow and profit do not have to follow the same trend lines. As we saw a moment ago with the £800,000 supplier scenario, a business can still be profitable whilst having inadequate cash flow and vice versa.
This is largely because money outside of sales-driven income, such as loans or transactions from your personal bank account, does not count towards profitability. Likewise, cash flow does not take into account any income that hasn’t yet been paid.
Here’s an example of how businesses can have a positive cash flow but poor profitability:
Derek takes out a £25,000 business loan in order to build new studios in his boutique gym. The loan has positive implications for cash flow, showing an additional 25k in the pot. But it won’t make any difference to profit as it doesn’t count towards direct income. In fact, sales have actually taken a dip and income is down on the last year. Cash flow is high, whilst profitability is struggling.
Being sensible with cash flow and profitability
It sounds counter-productive, but increased sales can be detrimental to cash flow. You’ve got to spend money to make money, as the idiom suitably suggests. So, in order to boost sales, you must be sure that you have the resources in place to support this. And in order to do this, you must study your cash flow report carefully.
Due to their precarious nature, profit reports should not be used to make critical purchasing decisions. In worst case scenarios, poor cash flow can lead to bankruptcy. Your profit margins may look good, but it doesn’t mean that your cash flow is following suit – particularly if you’re waiting for a chunk of money to come into your bank account.
Instead, use profitability to steer your sales staff and to showcase your success to investors. And use your cash flow to navigate your financial peaks and troughs.