Commonly, the relationship between profit and cash flow are confused. Many small business owners don’t understand the distinction between “profitability” (as presented on a Profit & Loss report) and the true health of the business from a cash flow perspective.
The true meaning (put simply)
It is essential for business owners to understand what profit means and why it has become almost a universal measure of business success. And more so, not only understanding what the profit figure tells you about your business, but more importantly, what it doesn’t tell you.
Profit Vs. Cash
Profit is generally the income of the business less expenses. This is usually viewed on a “non-cash basis” which means, the numbers shown on a Profit & Loss report are not based on what is physically collected or paid. Rather, it reflects what may have been invoiced by your business, or expenditure invoiced to your business.
Cash on the other hand, is just that: the cold, hard stuff in your hot little hands. Cash flow, is the movement of cash in the business and how much “profit” is available in real cash for business operations and liquidity.
Now the differences between profit and cash are clear, it’s easy to see both are crucial indicators of business success.
Profit and cash in practice
There are common reasons that lead to poor cash flow, despite potentially positive profits on paper:
- Slow paying customers
- Excessive owner drawings or shareholder loans
- Repayment of existing debts
- Purchase of capital assets
All of the above circumstances result in a different ‘cash position’ then the Profit & Loss statement may indicate.
A slow paying customer can mean income shown on a Profit & Loss report may not actually result in that amount of cash being in your account.
Similarly, if an owner draws out cash received for personal use, or chooses to buy an asset or pay down debt, neither of these transactions appears on a Profit & Loss report. Highlighting a difference between “profit” and the actual cash in your bank account.
Managing profit and cash
Procedures need to be implemented to control and measure profit and cash. One of the simplest ways to manage this is to regularly run a Profit & Loss Report on a “cash basis”.
A Profit & Loss Report on a Cash basis is available in all major accounting softwares and shows the true “cash” income and expenses for the business, as distinct from your standard Profit & Loss report.
Most current accounting software also features a “cash summary report” function, which shows ALL cash flow transactions in and out of the business, including items such as owner drawings, purchase of capital assets and repayment of debts.
Understanding the distinction between profit and cash, whilst running regular reports on both will significantly assist in ensuring you’re profitable AND cash flow healthy: an essential combination in any successful business.
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