The Critical Differences Between Cash Flow and Profit
Even if you’re not an accounting expert, misunderstanding cash flow and profits is bad for business. Here’s a crash course.
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Kirk W. McLaren is an Entrepreneur's Organization (EO) member in Washington, D.C. and CEO of Foresight CFO, a strategic financial management and accounting services firm that performs hands-on responsibilities to help businesses achieve optimal growth. We asked Kirk to discuss the difference between cash flow and profit and how both impact business success. Here's what he shared.
Business Success: Beyond Red and Black
It is pretty easy to oversimplify success or failure in a business by reducing it to commonplace terms: black and red, assets and liabilities, boom and bust, profit and loss.
The reality is more complex. In fact, it is so complex that it's possible to be a profitable business without being an entirely successful one.
Confused? It's all about cash flow.
There is a common misconception among many business owners that profits and cash flow are the same thing. They are not. For a business to thrive, it must generate profits while also operating with positive cash flow. The two terms represent different financial parameters, but in order to thrive, every entrepreneur must have a solid system to keep track of both.
The availability of cash can truly make or break an organization. Cash flow, not profit, determines viability. In fact, one study found that 82 percent of businesses fail as a result of poor cash flow management.
The Meaning of "Cash Poor"
By definition, profit--also called net income--is the surplus after all expenses are deducted from revenue, and it is the basis on which tax is calculated.
On the other hand, cash flow is the amount of available cash within a business at any given time as a result of the inflow and outflow of money. Moreover, profits and cash flow can exist in varying degrees of balance. Consider:
- High profit and low cash flow results in a profitable business unable to pay its bills. How can this happen? If the product you're making is selling for a higher price than what it costs to manufacture, you have a profitable basis for a business. However, the devil is in the details. Many wholesale customers hold invoices for up to 120 days before payment--meaning you may make the sale and deliver the product, but not get your money quickly. If your material suppliers demand payment on delivery of goods, that's a gap of up to three months after you pay suppliers but before receiving payment from your buyers. So, even though you are making a per-unit profit, you may be unable to meet your financial obligations during those lean three months while you wait for your invoice to be paid. In a worst-case scenario, this situation can send a profitable company into bankruptcy.
- Just because a business can pay all of its bills doesn't mean it is profitable. Here's another case: If you've borrowed money to solve a cash flow problem, the increasing debt on that loan could cause your per-unit cost to exceed the break-even point, and your business will no longer be profitable even though you have cash on hand. You could also experience increases in production volume that might cause costs to rise above a profitable level. Growth costs money, and if you suffer from negative cash flow, your growth will be stunted even when there is strong market demand.
Cash is the lifeblood of any business, and the key indicator of financial health. Cash is necessary for daily operations, taxes, purchasing inventory, meeting payroll, and to satisfy other short-term financial obligations.
Manage Liquid Assets Responsibly
Regardless of how great your product or business model is, you will not survive if you cannot manage your company's cash. Small-to-medium businesses are at highest risk of being "cash poor" because they constantly re-invest profits into the operation. Larger, more established businesses frequently have a cash reserve.
Don't let your entrepreneurial dream become a negative cash flow nightmare that isn't ideally positioned for growth. Good cash flow management doesn't happen by accident. It takes planning, and often, professional assistance. To ensure that your company implements the right plan to manage your liquid assets responsibly, consult with an experienced strategic financial management firm. By conducting a step-by-step cash flow analysis and planning ahead for gaps between accounts payable and accounts receivable, you can be sure you'll have the necessary cash flow to grow and invest wisely when opportunities arise.