Cash flow and profit are both important financial metrics in business, and it isn’t uncommon for those new to the world of finance and accounting to occasionally confuse the two terms. But cash flow and profit are not the same things, and it’s critical to understand the difference between them to make key decisions regarding a business’s performance and financial health.
For investors, understanding the difference between profit and cash flow can make it easier to know whether a profitable company is actually a good investment based on its ability to remain solvent in times of economic crisis. For entrepreneurs and business owners, understanding the relationship between the terms can inform important business decisions, including the best way to pursue growth.
What is Cash Flow?
Cash is constantly moving into and out of a business. When a retailer purchases inventory, for example, money flows out of the business toward its suppliers. When that same retailer sells something from inventory, cash flows into the business from its customers. When the retailer pays its workers or utility bills, cash flows out of the business, toward its debtors. When the retailer collects a monthly installment on a purchase that a customer financed 18 months ago, cash flows into the business. The list goes on.
Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time.
Cash flow can be positive or negative. Positive cash flow indicates that a company has more money moving into it than out of it. Negative cash flow indicates that a company has more money moving out of it than into it.
- Operating cash flow: This refers to the net cash generated from a company’s normal business operations. In actively growing and expanding companies, positive cash flow is required to maintain business growth.
- Investing cash flow: This refers to the net cash generated from a company’s investment-related activities, such as investments in securities, the purchase of physical assets like equipment or property, or the sale of assets. In healthy companies that are actively investing in their businesses, this number will often be in the negative.
- Financing cash flow: This refers specifically to how cash moves between a company and its investors, owners, or creditors. It’s the net cash generated to finance the company and may include debt, equity, and dividend payments.
The Cash Flow Statement
Cash flow is typically reported in the cash flow statement, a financial document designed to provide a detailed analysis of what happened to a business’s cash during a specified period of time. The document shows the different areas in which a company used or received cash and reconciles the beginning and ending cash balances.
What Is Profit?
Profit is typically defined as the balance that remains when all of a business’s operating expenses are subtracted from its revenues. It’s what’s left when the books are balanced and expenses are subtracted from proceeds.
Profit can either be distributed to the owners and shareholders of the company, often in the form of dividend payments, or reinvested back into the company. Profits might, for example, be used to purchase new inventory for a business to sell, or used to finance research and development (R&D) of new products or services.
Like cash flow, profit can be depicted as a positive or negative number. When this calculation results in a negative number, it’s typically referred to as a loss, because the company spent more money operating than it was able to recoup from those operations.
- Gross profit: Gross profit is defined as revenue minus the cost of goods sold. It includes variable costs, which are dependent upon the level of output, such as cost of materials and labor directly associated with producing the product. It doesn’t include other fixed costs, which a company must pay regardless of output, such as rent and the salary of individuals not involved in producing a product.
- Operating profit: Like operating cash flow, operating profit refers only to the net profit that a company generates from its normal business operations. It typically excludes negative cash flows like tax payments or interest payments on debt. Similarly, it excludes positive cash flows from areas outside of the core business. It’s sometimes referred to as earnings before interest and tax (EBIT).
- Net profit: This is the net income after all expenses have been deducted from all revenues. Typically, this includes expenses like tax and interest payments.
The Income Statement
Information about a company’s profits is typically communicated in its income statement, also known as a profit and loss statement (P&L). This statement summarizes the cumulative impact of revenue, gains, expenses, and losses over the course of a specified period of time.
The Difference Between Cash Flow and Profit
The key difference between cash flow and profit is that while profit indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a business.
Which Is More Important: Cash Flow or Profit?
Investors and business owners are often in search of a single metric by which they can understand the health of a company. They want to know the one number they should look at to determine whether they should make an investment, or pivot their business strategy. Cash flow and profit, as two critical and related financial metrics, often get pitted against each other: Which is more important?
There isn’t a simple answer to that question; both profit and cash flow are important in their own ways. As an investor, business owner, key employee, or entrepreneur, you need to understand both metrics and how they interact with each other if you want to evaluate the financial health of a business.
For example, it’s possible for a company to be both profitable and have a negative cash flow hindering its ability to pay its expenses, expand, and grow. Similarly, it’s possible for a company with positive cash flow and increasing sales to fail to make a profit, as is the case with many startups and scaling businesses.
Profit and cash flow are just two of the dozens of financial terms, metrics, and ratios that you should familiarize yourself with to make informed decisions about a business. By gaining a thorough understanding of key financial principles, it’s possible to advance professionally and become a smarter investor or business owner.
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