“Should I be focusing on the cash or the profit?” is probably the most frequently asked question in business.
While both are crucial aspects of a business, cash flow is definitely king when it comes to financial management of a company.
The reason for this is very simple: if you don’t know how to manage your company’s cash on a day-to-day basis, it’s very likely that your business won’t get far.
As a matter of fact, you could easily run out of business even if your company is profitable.
How is that possible?
Before we explain why this scenario is possible and why you should start paying more attention to cash flow, we’ll have to explain what exactly profit and cash flow are, as many business owners have difficulty recognizing the difference between the two.
Profit vs. Cash Flow: What’s The Difference?
Profit is the difference between a company’s income and its expenses.
It’s what remains after you subtract all the company’s expenses – including the expenses directly related to the creation of goods that were sold, and the cost of all the operating expenses such as rent, electricity, payroll, advertising etc.
For example, if you sell $50,000 of goods and it cost your business $40,000 to produce those goods and operate in the meantime, your resulting profit is $10,000.
Simply put, being profitable means that you make more money that than it costs you to produce goods or provide a service.
However, it’s important to mention that profitability is an accounting concept that is based on how much you have invoiced customers and it doesn’t take into consideration the amount of cash that is actually paid or received.
Moreover, income statements that show the profitability of a business don’t take into consideration some of the costs that do exist but are not directly related to the cost of production and operations, e.g. taxes and business loans that need to be paid off.
Cash flow, on the other hand, is the actual inflow and outflow of money from a business that happens every day, week, month, quarter and year.
Cash flows in from sales, loans, investments and other sources and flows out for direct expenses, operating expenses, debt payment etc.
Unlike profit, cash flow has a real-time dimension to it and can, therefore, be a very real measure of how a company is doing and whether it has enough resources to cover the costs of its daily operations.
This is because cash flow is registered once the money is actually deposited into your bank account or given to you as cash (inflow), or on the precise day when you pay for a particular expense and the money leaves your bank account (outflow).
In a nutshell, cash flow records only actual cash transactions.
Why Should You Care?
Now that you understand the basic difference between profit and cash flow, we can go back to discussing the point why it’s important to start paying more attention to your business’s cash flow management.
Don’t get it wrong, that isn’t to say that profit is not important – it is. If there’s no profit or the profit is too small, the cash flow will also start declining.
However, all too many business owners obsess over profit without understanding the actual impact cash flow management has on the very survival of their firms.
Take, for instance, this scenario: Your company sells $100,000 in goods and invoices the buyer with the full amount this month.
Once the customer is invoiced, this $100,000 is registered as revenue for that month and gets included in the income statement. Things look fantastic on paper, but they don’t have to be as fantastic in reality.
Most of the companies don’t get paid the full amount immediately but rather receive payments in stages.
So let’s say your company will be paid in 4 stages of $25,000, each with a 30-day payment limit. This means the first payment will arrive somewhere around a month from now.
And that’s only going to be 1/4 of the full amount. (We won’t even mention the scenario where your customer goes out of business and is unable to pay you.)
And how are you going to pay the bills? The paper says you’ve made $100,000 in sales, but if you haven’t been paid yet, there’s no money in the bank.
There’s no money to pay the rent, no money to pay the workers, no money to invest into new production.
You might take a loan from the bank this time, but you definitely won’t be able to do it all the time.
So you’re profitable – you’ve made sales and your income is larger than your expenses, but you still have no real cash to cover your expenses when you need to do so.
The above scenario reflects a very frequent cash flow problem that occurs because the time gap between making sales and receiving payment is too wide.
In this case, cash flow is much more important for the company than profit simply because it enables it stay afloat and continue trading.
If you prioritize tracking and analyzing your cash flow, you will be more aware of both the up and down patterns of your bank account balance, as well as all the upcoming bills that will need to be paid.
And after tracking your cash flow for a few months, you’ll also be able to predict when the shortfalls are going to occur so you can come up with a solution that will help you get through the difficult period.
You could, for instance, offer customers a discount for shorter payment terms and speed up the inflow of cash this way (the so-called ‘early settlement discount’).
Or, you could get a loan from a bank to keep the business running until the payments start arriving. Simple solutions are also not excluded, like phoning your landlord and asking for a few days of extension.
Regardless of whether you’re a startup, small business or a corporation, your firm can benefit from tracking and improving its cash flow.
Not only can it benefit, but, what’s even more important, it can avoid the faith of those 82% of businesses that fail because of poor understanding of cash flow and poor cash flow management skills. (research by Jessie Hagen of U.S. Bank)
So, if cash flow hasn’t been your company’s priority, it’s a good time to start thinking how you can improve it.