As a small business you may find yourself confused about the difference between cash flow and profitability. The most simple definitions of the two say basically the same thing, “cash flow is the difference between accounts received and paid” compared to “profitability is the difference between revenue and expenses.” Sounds very similar, does it not?
Yet, both definitions are actually different because the report on separate parts of your business, which is why it is important to understand and report on both. That being said, reporting on cash flow or profitability can not be done until you fully understand the difference between the two. Financial statements like these two are essential to understanding the company’s performance as a whole.
What is Cash Flow?
Cash flow is the difference between the amount of cash/money made and the amount of money spent on things like rent, bills, loans and other accounts payable. It is literally a flow of money in and out of the business.
Cash flow is basically a representation of your business’s bank account. Positive cash flow is when the amount made is greater than the amount paid for bills while negative cash flow is when the amount earned is less.
Having positive cash flow when starting up a small business will take some time. That is why it is important for a startup to have cash reserve for at least 6 months. One of the top reasons why businesses fail is because of having the lack of cash to keep the business stable until profits start being earned.
How do you analyze your business’s cash flow?
When analyzing cash flow, you must look at the amount of money earned from your product or service being sold, cash inflow, and subtract it from all business expenses, cash outflow. The expenses are the added up amount of money needed for bills, payroll, rent, product costs, etc. If you find that you have more purchases (expenses) than cash earned, you will find yourself having negative cash flow, which will cause take out more money from future income to make up for the missing cash.
You may find yourself getting very excited about having your first positive cash flow month because you probably equate positive cash flow as profit, but that is not always the case.
For a simple example: Let’s say you send out an $5000 invoice, this amount is recorded as profit, but that does not take into account that the client will pay it on time. When it comes to paying expenses, you may find you do not have enough cash on-hand because the client has not paid the invoice on time. This causes a negative cash flow, but the records still say that you have made profit. Cash flow is the amount flowing in and out of your bank account not the profit amount on paper.
Take a look at this example that gives a more detail example to understand how positive cash flow does not equal profit.
What is Profitability?
As stated in the beginning definition, profitability is made of two parts: revenue and expenses. As you are aware, making income, or revenue, is not free and costs money in form of rent, bills, payroll, product material, etc., i.e. expenses. Now that may still sound like the same parts that make up cash flow, but cash flow is the money flowing in and out of the company at any time while profitability is usually booked, planned income and expenses at a set period.
How do you analyze your business’s profitability?
Profitability takes revenue and expenses into account and then determines how well the company is doing and can predict if there is any future growth.
Going back to the cash flow example from before the invoice of $5000 is sent to the client. The books record this as $5000 in revenue, but the cost of tools needed for this job is $1500 leaving you with $3500 in gross profit.
Then with the $3500 in gross profit you must find the net profit, gross profit minus the operating expenses. Operating expenses for the job is $2000 leaving you with $1500 in profit or profitability for that period.
To sum it up, cash flow and profitability are related, but they do not go hand in hand. Positive cash flow does not mean you have a profit and vise versa. Again, cash flow simply is the amount coming in and out of the company at any given time, while profitability looks at expected revenue and expenses to determine net profit. Cash flow gives you a daily look of how your business is doing, while profitability reports on the overall success and profits of your business.