Understanding Business Profit and Business Cash Differences
Understanding the difference between business cash flow and profits or net income can mean the difference between success and failure for your business. While profits are important to a business, they aren't as important as cash. Businesspeople need an understanding of how business cash flow is more important than the company's net income.
Cash vs. Profits
Profits are the net amount on a profit and loss statement. They are the result of sales minus expenses. That's not the same thing as cash. Think of it this way: Profits are an accounting and tax concept, that comes into play at the end of an accounting period and at tax time. Profits are the result of a calculation; Cash is the result of banking transactions.
Cash is the money in your business checking account. It's what your business receives when you sell a product or service.
Cash Flow vs. Net Income
Cash flow refers to the movement of money into and out of your business, through your business checking account. If the net cash flow is positive (more cash coming in than going out), that's good. If it's negative, it means your business is spending more than it's collecting. Notice I used the word "collecting," not selling.
Net Income for a business is shown on a net Income statement, but only at the end of a month, quarter, or year. It doesn't help you figure out how to deal with the ups and downs of cash during a month.
How Can My Business Have Profits But No Cash Flow?
To answer that question, I need to bring the concept of accounting methods into this discussion. There are two accounting methods - cash and accrual. An all-cash business uses the cash accounting method. Income is received when money (check, credit card) changes hands. In accrual accounting, income is received when the bill or invoice is sent, not when you receive the money.
In accrual accounting, let's say you did some web design work for a client. You send the client an invoice for $3,100. You now have a sale of $2,100, on your profit & loss statement, but the money isn't in the bank - no cash yet.
Your Business Bank Account
Now let's look at your business bank account. There is $3,000 in the bank account from previous sales. You need to pay rent on your office space today - that's $1100. You also need to pay utilities ($220) and the freelancer who helped you with the web design project ($850). That takes $2160 out of your business bank account. You need to take out $1000 to pay yourself and pay your personal expenses, but you can only take out $830, which leaves you with a balance of $0.
Your business profit for the month so far is $3100 sales minus $2170 in business expenses, for a profit of $930. You can spend that profit if you want, but it will mean running your business bank account into the red.
Other Accounts Affect Profits and Cash Flow
Profits incorporate all business expenses, including depreciation. Depreciation doesn't take cash out of your business; it's an accounting concept that reduces the value of depreciable assets. So depreciation reduces profits, but not cash.
Inventory and cost of goods sold also affect profits, but not necessarily cash. For example, you have to buy products to put into inventory and pay for those products. That comes out of cash, and you might have a profit on the ultimate sale of that product, but in the meantime, you're still out the cash.
Make it a priority to get information about your monthly cash in and cash out. I use a Google Sheet, or you might be able to talk your accountant into giving you a cash flow worksheet. Include timing of income and expenses, and don't forget your own salary or draw as the business owner. Getting a handle on cash flow can help you sleep at night and be a big benefit to your business success.