Profit and cash flow are both important elements of a healthy, growing business, but they are not the same thing.
As Accountiful founder told us, “The thing that sinks entrepreneurs again and again is conflating profit with cash flow. Just because a business is profitable doesn’t mean it’s got sufficient cash flow to sustain itself.”
To manage your business, you must understand the difference between making money and managing money. Growing businesses often face tighter margins and increased expenses—and it’s not a good idea to try to “out earn” cash problems. You may be great at selling, but it’s time to get great at forecasting and budgeting as well.
How Profit and Cash Flow Are Different
Profit is defined as revenue less expenses. It may also be referred to as net income. Cash flow, on the other hand, refers to the inflows and outflows of cash for a particular business. Earning revenue does not always increase cash immediately, and incurring an expense does not always decrease cash immediately.
Assume, for example, that Birchett Mowers manufactures and distributes lawn mowers through hardware stores and other retail locations. Here are three points that illustrate the differences between profit and cash flow:
- Revenue Generated: Birchett sells a $300 lawn mower to a retail store on June 1st, and emails an invoice. The business posts $300 in revenue, but the retailer doesn’t pay the invoice until June 30th. Revenue is posted immediately, but the $300 in cash is not collected for 30 days.
- Expense Incurred: Birchett pays $270 in expenses for the lawn mower that was sold. Those expenses are paid in April and May, before the sale of the lawn mower. The business has $270 in cash outflows in April and May before collecting $300 on June 30th.
- Profit Recognized: The profit generated on the lawn mower sale is ($300 – $270 = $30), and that profit is posted on June 1st. In accounting terms, revenue can be recognized on June 1st, because the sales process is completed when the product is delivered. The $30 profit is not collected in cash, however, until June 30th.
While Birchett must wait to collect its receivables, other companies do not have this issue. Many businesses collect cash from customers at the point of sale. A retailer, such as Walmart, receives customer payments at the point of sale through debit card and credit card purchases.
This system allows a retailer to collect cash quickly, and makes the cash management process much easier. Birchett’s cash management planning, however, is more complicated.
Cash Flow Management Is Different for Every Business
Birchett earned a $30 profit on the lawn mower sale, but had to pay $270 in cash to make and deliver the product to a customer. The firm also had to wait 30 days after the sale to recover the $270 paid in cash and collect the $30 profit. The more products Birchett sells, the more cash it must spend. This situation requires precise cash flow management.
Here are several sources of cash flow for Birchett:
- Collections on prior sales: Cash collections from sales in prior months can provide cash to make and deliver products. April and May sales collected in June can provide cash for June manufacturing costs. However, if Birchett’s sales are increasing, cash collections from past months may not be sufficient for current production cash needs.
- Delaying cash payments: Birchett may be able to delay cash payments, which would reduce the total amount of cash needed for production each month. Assume, for example, that Birchett purchases metal and other raw materials from Standard Machine. The two parties sign a contract that requires Birchett to deposit 20% of each order in cash, and pay the balance in 25 days. This arrangement will improve Birchett’s cash position.
- Raising capital: If Birchett cannot finance its cash needs through business cash flow, it may need to raise additional capital. Businesses can raise capital by issuing stock, which means that an investor purchases ownership in the company in exchange for cash. Birchett can also raise capital by borrowing funds.
Raising additional capital is the least attractive option for cash management. If Birchett issues stock, the owners are selling a percentage of their interest in the company. Issuing debt requires the company to make interest payments on debt, and repay the original principal amount borrowed on time.
Most companies must issue stock or debt to raise enough funds to operate the business.
Increased Sales Can Create Cash Flow Problems
Every business wants to increase sales, but if cash collections do not increase at the same rate, a firm may quickly run short on cash.
Assume that Birchett shifts its marketing focus to a $300 lawn mower that generates a higher profit of $45. Total sales in July increase from 1,000 to 1,500 lawn mowers. While Birchett’s total profit is higher, the firm must have available cash to produce 500 more lawn mowers that are sold in July.
Situations like this can create a cash crisis. Birchett may accept orders for more lawn mowers, then realize that it doesn’t have enough cash to produce more products. The owners may have to quickly sell stock or find a lender to raise cash, which is not a choice the owners would normally make. Because the firm is under pressure, the owners may sell more ownership or pay a higher interest rate on a loan then they intended.
Plan Cash Flow Carefully
Higher profits are a great objective, but meeting the cash needs of your business requires careful planning. Make sure that you understand the differences between profit and cash flow, so that you can grow your business with sufficient cash flow.
Editor’s note: This article was originally posted by Ken Boyd on the QuickBooks® Resource Center.
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Source: QuickBooks Blog