Net Profit vs Cash Flow
UNDERSTANDING THE DIFFERENCE BETWEEN PROFIT AND CASH-FLOW IS ESSENTIAL TO THE SUCCESSFUL OPERATION OF A SMALL BUSINESS...
Preface: This post is not intended as an instructional manual for accountants or bookkeepers, but rather as a conceptual guide for small-business operators and would-be small-business owners who may not be adequately familiar with these critical core business concepts.
Profit is a financial benefit that is realized when the ... revenue gained from a business activity exceeds the expenses ... needed to sustain the activity.
Profit is what's left over from Revenue after you've paid all of your costs in doing business. But profit is not the same thing as cash since profit can accumulate in a number of different forms.
For example, if you buy a piece of property at, say, $100,000, and in the first year, its reliable market value goes up to an average $120,000, you've made (at least, on paper) a $20,000 profit.
However, if you check your pockets or your register drawer, you will not find an extra twenty grand laying around there. In other words, you've made a profit, but you haven't generated any cash. And you won't until you sell the property or borrow against the increase in the property's market value.
Similar circumstances can come up in business. You may be making a healthy net profit on your gross sales revenue, but that profit might be tied up in accounts receivable ― payments owing to you from clients or customers for goods or services you've already delivered. Or you can have profit tied up in inventory you've already paid for but haven't yet sold or in equipment you've paid for but which has many years of useful life remaining. Such items represent value and equity in your business and, as such, are repositories of profit. But unfortunately, they are not cash.
The problem is you need cash to pay any employees who may work for you. You need cash to pay for rent, utilities, and other current recurring expenses. And you can need cash in order to purchase goods for eventual delivery to your clients and customers.
Which is why more than a few small businesses have been forced to close for lack of available cash, even when they were solidly profitable.
There are several potential sources of incoming cash in a business: sales revenues, investment dollars, loan proceeds, and retained net profits. If the current total inflow of cash is sufficient to cover your current necessary outflow (expenses), then you can stay in business. But that doesn't mean your business is profitable.
Even when you have enough cash to pay your bills every month, you may still be operating at a net loss. Here's why.
If you're using a current inflow of investment dollars to pay your current operating expenses, you're taking in investment, but not building equity or value in the business. And if everything remains the same, when the investment inflow dries up, at some point you will no longer be able to keep the doors open or the lights on.
It's the same if you're using loan proceeds to pay for current operating expenses, except worse because using loan proceeds to stay open simultaneously builds debt that has to be serviced with ― you guessed it, cash.
Robbing Peter to pay Paul cannot go on forever (except perhaps in the case of Amazon) because eventually the growing debt requires more cash to service than you have available ... and you will go out of business.
There is a tendency these days to concentrate on cash flow while not being much concerned with profit. This attitude is a carry-over from the practices of large companies that attract truckloads of investor cash as a result of selling shares in the company.
Sometimes such companies can survive for years, even decades on the cash flow thus generated, while at the "back end" racking up negative profits (losses) each year. Investors in such companies don't really care because they are more interested in trading the stock of the company in an effort to generate their own profits, as opposed to sharing in the net proceeds thrown off by owning a share of a profitable company.
Focusing on cash flow alone may work for companies like Amazon ― which historically operated at a fiscal loss for almost two decades. But it rarely, if ever works for small businesses, which almost always have to generate profit in order to remain viable.
Plain and simple, profit is what's left over from sales revenues, after you've paid all of the costs involved in producing those revenues. In a perfect ― and simple ― world, that profit would be in the form of cash that could be re-flowed back into the business in the service of building value and equity.
Unfortunately, more often than not, a portion of the profit shown on paper exists in the form of non-cash assets of the business. Which is why it's essential for a small-business person to understand the difference between profit and cash flow, and continually keep an eye on both.
― Phil Friedman
Postscript: One of the key financial skills needed by a small-business person is the ability to manage cash flow and, as needed, convert non-cash repositories of retained profits into operating cash. We'll deal with some tips for accomplishing this in a future installment of this series. ― PLF
Author's Notes: If you found this article worthwhile, you might want to takes a look at the following posts:
You might also be interested in my new eBook, Small-Business Primer: Real -World Tips for Starting and Running Your Own Small Business.
For information on securing a copy, email email@example.com and put "small-business book" on the subject line.
Are you starting up or currently operating a small business and facing a problem or issue on which you could use some help? Consider our offer below:
About me, Phil Friedman: With 30 some years background in small business and the marine industry, I've worn numerous hats — as a yacht designer, boat builder, marine operations and business manager, marine industry consultant, marine marketing and communications specialist, yachting magazine writer and editor, yacht surveyor, and marine industry educator. I am also trained and experienced in interest-based negotiation and mediation. In a previous life, I taught logic and philosophy at university.
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