There’s an old saying in accounting that goes: “profits are an opinion, cash is a fact.” What this means is that while being profitable is important in the long term, having enough cash to operate day-to-day—that is, having a positive cash flow—is a more immediate, pressing concern.
“Businesses don’t often live or die on profit alone,” explains Spotlight Reporting CEO Richard Francis, FCA. “There’s all sorts of accounting jiggery-pokery you can do to get the numbers to look the way you want, but if the cash isn’t coming in, it can all be over really quickly.”
As a business owner, it’s important to understand the difference between cash flow and profit, and how both factor into business success. Although it’s counterintuitive, a profitable business could be forced into bankruptcy because of poor cash flow. Similarly, a business could be cash flow positive, and still be losing money.
So what’s the difference between cash flow and profit? More importantly, how can you make sure that you’re both profitable AND have positive cash flow?
What is Cash Flow?
In a nutshell, cash flow refers to the flow of money into and out of a business during a set period of time. Cash flow accounting records transactions at the point when money enters or exits your bank account, rather than when an invoice is sent or received.
Unlike a Profit and Loss statement, cash flow includes cash growth that isn’t strictly profit, like capital injections from owners or investors, or money from the sale of an asset. Similarly, it doesn’t include credit from suppliers, money owed from customers, or money you already have in the bank.
Positive cash flow means that you have more cash incoming than outgoing at any given point in time, and you’re meeting all your financial obligations as they arise. It’s a metric often used to measure the health of a business, and can show banks, shareholders, and investors how well a company is doing day-to-day.
What is Profit?
Profit, also known as net income, is the amount of money remaining when you subtract costs from sales revenue. There are two main types of profit:
- Gross profit = sales revenue - cost of goods sold
- Net profit = sales revenue - cost of goods sold and business expenses (includes rent, payroll, taxes etc)
Unlike with cash flow, a monthly or quarterly Profit and Loss statement takes into account what you owe, and what you are owed for the period. Because of this, it’s a good indicator whether or not your business is making more money than it spends overall—but won’t tell you whether you currently have enough money in the bank to pay the bills.
The Difference Between Cash Flow and Profit
Put simply, a Profit and Loss statement shows whether your business is earning more than it’s spending, while a Cash Flow statement shows when you’ll have cash in hand. Profit is about the bigger picture, while cash flow focuses on day-to-day viability.
In order for a business to be successful, it needs a good profit margin and positive cash flow.
Good Profit, Poor Cash Flow
Selina owns a small, community-focused bakery that serves high-quality pastries to a local crowd.
A friend of hers posts a picture of her best-selling chocolate croissants to Instagram, and interest in her bakery picks up. In just over a month, demand for croissants doubles, and Selina finds herself regularly running out of stock.
In order to keep up with demand, she invests in new equipment, and doubles her regular order of supplies.
Unfortunately, although the new revenue would more than cover the costs in a few months' time, Selina is in the red when it comes time to pay her suppliers. She is forced to take out a high-interest loan to meet her debts, forcing her further into the red.
Despite a healthy profit margin, poor cash flow nips Selina’s growth plans in the bud.
Good Cash Flow, Poor Profit
Parita owns a construction company, focusing on building high-density, affordable housing. She’s always prided herself on paying her workers, suppliers, and bills on time.
Parita operates cautiously, avoiding loans wherever possible, timing incomings and outgoings so she can always meet her obligations. Despite her focus on affordability, the business has always turned a tidy profit.
What she doesn’t anticipate however are the rising costs associated with supply chain disruption. The pandemic causes delays and increases expenses across the industry, and Parita’s business is no different. Because contracts were already in place with buyers for her builds, the costs eat into her already slim profit margins.
Parita’s business remains cash flow positive throughout the financial year, but the lack of profit means her business model is no longer maintainable.
The Right Balance
Johnny is a musician, with a fairly large international following. At the request of his fans, he’s planning his first-ever overseas tour.
He and his management team quickly work out that a tour is feasible, but Johnny doesn’t have enough cash in the bank to pay upfront costs like venue hire, sound and lighting technicians, ticket services etc.
They put together a budget for the trip, and create a forecast exploring how many tickets they’d have to sell in order to pay back a bank loan. They also look at a worst-case scenario, in which they sell 20% fewer tickets than they anticipate. They find that in this situation, they can still cover their costs and make a profit if they find cheaper accommodation, and take public transport between cities.
Armed with this information, Johnny is able to confidently apply for a bank loan. The tour goes off without a hitch, and Johnny ends up selling out most of his concerts. The bank loan is repaid on time, and Johnny and his management team walk away with a hefty profit.
How to Ensure Good Profit and a Healthy Cash Flow with Spotlight Forecasting
Managing cash flow and profit margins means measuring, monitoring, and making a plan to meet your goals. The easiest way to do all of the above is to create a financial forecast. This is where Spotlight Forecasting can help.
“You can do it by hand with Excel, but that takes so much time,” says Marie Phillips, Founder and CEO of Connected Accounting. “When everything's already in the cloud and you have it in Xero, it's so easy to link it to tools like Spotlight. And once you're in Spotlight you can do multiple versions: let's keep business running as usual, let's look at a best case scenario, and let's look at the worst case scenario."
You can use our three-way forecasting software to project your future cash flow, budget, and profit and loss, so you can stay prepared for whatever lies ahead. You can also create a range of scenarios and put together a plan of action for different eventualities.
Most importantly, you can use Spotlight Forecasting to ensure ideal profit margins, and identify periods of low cash flow so you can compensate accordingly. It’s like being able to look into the financial future—without the hassle of a crystal ball.