What is the difference between cash flow and profit?
Both of these terms are related to a company’s income and expenses so it can get pretty confusing to distinguish between the two.
Cash flow and profit are two very similar terms in finance. Today, we’ll learn the difference between these two by looking at their definitions and understanding them in-depth.
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What is Cash Flow?
Cash flow is defined as the net balance of cash moving into and out of an organization at a specific time. It can be both positive and negative. Positive cash flow means the company has more money coming into it than going out of it. On the other hand, negative cash flow means the company has more money going out of it than coming into it.
Cash moves constantly in and out of a business. You can understand cash flow better with the following example:
When a manufacturer buys raw materials from the supplier, cash moves out of their business. After that, when the same manufacturer sells goods created from that raw material to other businesses, money flows into their business.
Apart from buying raw materials, there are multiple ways cash can flow out of a business such as payment of utility bills, paying debtors, and paying the staff’s salaries.
In our example, if the amount of cash flowing into the manufacturer’s business was higher than the money going out of it (payment of bills, raw materials, etc.), then their business would have a positive cash flow. Alternatively, if the amount of money going out of their business would be higher than the amount of money coming in, they would have a negative cash flow.
Categories of Cash Flow
We can divide cash flow into three categories:
1. Financing cash flow
Financing cash flow is how funds move between a company and its owners, investors, or creditors. It refers to the net cash produced to finance the company and might include equity, debt, and dividend payments.
2. Investing cash flow
Investing cash flow is the net cash a company’s investment-related activities generate. These activities include the purchase of physical assets (equipment, property, etc.) sale of physical assets, investments in securities, etc. Usually, this cash flow is negative as companies constantly invest in their business to facilitate growth and development.
3. Operating cash flow
Operating cash flow is the net cash a company’s daily business operations generate. To run a company properly and expand it continually, a positive cash flow is vital. It helps in maintaining the company’s growth.
Cash Flow Statement
You’d report the cash flow of your company in the cash flow statement. It is a financial document that provides a detailed analysis of what happened to a business’s cash during a specific time period. It shows the various areas in which the company received or used cash. It also reconciles the ending and beginning of cash balances.
Now that we have covered cash flow in our “cash flow vs profit” discussion, let’s now look at the definition of profit and see how it differs from cash flow:
What is Profit?
Profit refers to the remaining balance when all the operating expenses of a business are subtracted from its generated revenue. It is the remaining amount when you balance the books and subtract the expenses from the proceeds.
Depending on the nature of the organization, you’d distribute the profit to the shareholders and owners of the company. Usually, it is distributed in the form of dividend payments or is put back into the company as an investment. For example, you can invest the profits of your organization into research and development (R&D) of new products or purchase new inventory for your business to sell.
Just as we cash flow can be positive or negative, profit can have a positive or negative value as well. When your profit is negative, we call it a loss because it means the company spent more money on its operations than it generated from them. If it has a positive value, we call it a profit.
Types of Profit
We can divide profit into three categories:
1. Net profit
Net profit refers to the net income of a business after you have deducted all the expenses from its revenues. The deducted expenses here also include tax and interest payments.
2. Operating profit
Operating profit refers to the net profit a company produces from its daily business activities. Usually, it doesn’t include negative cash flows like interest payments on debt or tax payments, hence it’s different from net profit.
It doesn’t include positive cash flows from sections outside the daily operations of the business. Another name for operating profit is Earnings Before Interest and Tax (EBIT).
3. Gross profit
Gross profit is the remaining amount you get after deducting the cost of sold goods from the revenue. It consists of variable costs which depend on the level of your output such as the cost of labor and materials required for producing the product.
However, it doesn’t include fixed costs that the company must pay no matter how much output it has. These fixed costs include staff salaries, utility bills, rent, and other related expenses.
The Income Statement
You show the company’s profits and all the related information through its income statement. The income statement is also known as the Profit and Loss statement (P&L). It summarizes the total impact of gains, revenue, losses, and expenses during a specific time period.
Difference Between Cash Flow and Profit
By now, you must have an idea of what’s the difference between cash flow and profit. Profit refers to the amount a business has left after it has paid all of its expenses. On the other hand, cash flow is the net flow of cash coming into and moving out of a business.
A company can have a positive cash flow without making a profit. This happens when the cash comes from sources other than the company’s income, for example, when the owner takes out a loan or puts in their personal funds.
These are equity or liability transactions and would appear on the balance sheet. Conversely, a company can have a negative cash flow even if it makes a large profit. For example, if the owners of the business take the cash out of the company to pay their personal expenses or pay loans.
Such transactions will also appear on the balance sheet but not on the P&L statement.
The primary difference between cash flow and profit is based on accounting and the source of transactions.
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What are the 3 types of cash flows?
In general, the majority of companies should be monitoring and tracking 3 types of cash flows. Analysing all three can help in the determination of the company’s liquidity and solvency levels.
The 3 main activities of a cash flow statement involve cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The company’s financial statement will typically show all three of these cash flows.
Cash activities that are related to the net income come under the purview of operating activities whereas cash activities related to noncurrent assets are included under investing activities. Financing activities comprise cash activities related to noncurrent liabilities and owners’ equity.
Is profit more important than cash flow?
Cash flow is an important element that helps the business to operate on a day to day basis whilst maintaining a profit. With more cash flow in the system, your business is more liquid. If your business needs more funds to grow, having a steady cash flow opens up a host of opportunities to expand.
However, in the instance that there is an increase in the revenue and subsequently cash flow but then there is also debt, the business is not making low or no profit. In such situations, profit becomes more important than cash flow.
Therefore, both components rise in their importance depending on the situation.
How can profit be maximized by a business?
A business is able to successfully maximise profit when it runs at a point where marginal revenue is equal to marginal cost. A firm can continue to maximise profit by increasing average sales from existing customers, acquiring new customers and increasing the frequency of purchase among current consumers.