Some people will tell you the most important thing in a business is profit. Others will say, of small businesses in particular the most important thing is cash flow. If you are part of the remainder of people who will stand there and wonder what the difference is and if it even matters this is the right place for you to be. There is so much we have to understand in business and throwing this profit versus cash flow on top makes it all the more a daunting task. So, what’s what?
Profit is where we will start. It is a measure of the residual value realised after completing a transaction. In simpler English, it is the difference between the revenue realised from providing a product and the cost of providing the product. Simple. However, there are things we have to consider in this definition. Profit does not just include product costs but additional costs associated with making the product available. If you sold eggs for example the cost of packaging and transportation of the eggs also goes into the cost. Profit is the measure of how well a business is performing in terms of increasing the wealth of the owners of the business.
Cash flow on the other hand is a measure of how much money flows through the business. We are analysing how much and how fast money is coming into and out of the business. To explain this in simple terms let us imagine a bucket with a hole in it. If money were water, the water we put in the bucket would be cash coming into the business while the water that leaks out of the hole is money flowing out of the business. The outflows representing payments that need to make. If you can put water in the bucket faster than it leaks out, you will have a build-up of water. If you cannot add water as fast as it leaks out you will run dry. You will cease to make payments which will obviously upset your creditors at best and stop them from doing business with you at worst.
With the two definitions, I hope we can see the points where profit and cash flow are similar. Both are an indicator of how well the business is doing. Profit is a measure of value addition to business owners while cash flow is a measure of financial control by the business. They are also similar in their effect if they are prolonged for negative spells. Continuous negative profit (losses) will lead to the collapse of the business due to erosion of investment while continuous negative cash flow will result in the insolvency of the business. The two are connected, of course, if you are operating at a loss you are effectively dishing out more money than you are bringing in.
Through the definitions, we should also be able to see some differences between the two. Firstly you should’ve noticed that the effects of negative cash flow are likely to be felt immediately while operating in losses will not show up immediately. It may take some time before they impact the business. The other thing you would’ve probably noticed is that it is possible for a business to make a profit but have poor cash flow. Perhaps money is going out faster than it is coming in. Equally so a business can have good cash flow but be operating in losses.
What they mean for your business
Ultimately we should understand that both are necessary for long term business success. It is understandable if your business struggles with either or both of these in the short term. Some things can shock your cash flow. For example, if you have to increase your stock inventory but will have to wait to sell off the increased inventory to make the cashback. Negative positions in both are not immediate indicators of a business in trouble but they need to be monitored closely to make sure they do not prolong.