The Difference Between Profit and Cash Flow

Updated: December 9, 2022

Most company founders don’t understand the difference between profit and cash flow. Both metrics are critical in understanding the overall health of a company. However, not understanding this distinction could have a disastrous effect on your business.

Not having a firm grasp of both concepts could leave your company without enough cash on hand to pay your bills and push your business toward bankruptcy.

Take a closer look at the differences below so you can avoid these issues.

The Basics

Profit is, by definition, the difference between revenue and your operating expenses. It is sometimes referred to as net income.

There are three basic types of profit:

• Gross Profit: the profit that is left after all the costs associated with selling your products or services in a period of time.
• Operating Profit: the total profit of your company, without taking into consideration interests and taxes.
• Net Profit: all expenses, including taxes and operating costs, such as rent and payroll, from your gross revenue.

Cash flow measures the amount of money moving in and out of your business. It starts with profit and makes adjustments for items that profit fails to take into account. It is a constantly changing figure. If your cash flow is positive, it indicates your business has more cash on hand than it is paying out. If you have negative cash flow, then it indicates that your company has more cash moving out than coming in.

Flaws with Profit

Profit can be a deceptive measure of your company’s standing and ability to grow. That’s because of standardized accounting rules dictate how various business expenses are recorded. A positive financial performance can give the illusion that everything is going according to plan. But in practice, you operation can be experiencing trouble getting by.

For example, if you buy a new piece of equipment for your company, accounting rules require you to take the expense in increments. This practice, called depreciation expense, can make it appear that you have more profit in any given time period than is actually the case.

If you were to only look at your profit figures as the only metric of success for your business, then it could have a negative impact on your decision-making. Said differently, profit figures are important but are not the only relevant metrics in a business.

Why Does Cash Flow Matter?

Cash flow is the lifeblood of your company. You cannot pay for items with the accounting profits that are measured on your books. You cannot buy a piece of equipment or hire another employee without positive cash flow.

Cash flow is the money you have on hand to pay immediate and short-term costs. Without sufficient cash flow, your company may be unable to make a critical purchase, hire staff, or pay bills.

In other words, you can not run your day-to-day operations with a negative cash balance. If you come across a severe cash crunch that you can not solve quickly, you may have to rely on lines of credit. But this is expensive money since you’ll have to pay interest on it and adhere to its payment terms.

Cash Flow from Operations

Your financial statements will give you a clear indication of how much cash your business has made and how much you have on hand. Looking at the cash flow from the operations section of your financial statements gives you a clear indication of your cash availability.

In this case, cash is actual money the business has made versus profit which is not actual money but an accounting measure. The key difference between both of these concepts is that cash flow you can actually use because it is the literal amount of money you have available.

Differences Between Cash Flow and Profit

Calculating cash flow takes several deft accounting procedures to give you a clear indication of available money.

There are a few critical differences that are made when comparing profit to cash flow:

Depreciation

In profit statements, machinery and equipment expenses are recorded in incremental amounts over multiple years. These statements do not match the cash outflows in a given year to make those purchases.

With cash flow statements, machinery and equipment purchases are recognized fully in the year in which purchases are made and listed under “investing activities.”

Inventory

In profit statements, inventory is only expensed when it is sold. Inventory that is purchased and remains on-hand to be sold in the future is not factored in. Again, this does not match the actual cash outflows of the business.

On a cash flows statement, both: (1) inventory that is sold, and (2) purchased inventory on hand are factored as a cash outflow. This comes in handy when working on a cash flow forecast and other business planning activities.

Accounts Receivable

There can be a lag in cash reconciliation on profit statements. The reason? Sales sold on credit are recorded as revenue even if cash has not been collected.

Cash flow statements, however, remove sales sold on credit. They only count cash actually collected from customers. This means that depending on your business model, you may find a discrepancy between your sales revenue figure and your cash flow reports.

Deferred Revenue

On profit statements, cash received for future product delivery is not recorded as revenue,. Instead, it is recorded on the balance sheet, resulting in a mismatch relative to cash inflows.

For Cash Flow statements, cash received for future product delivery is included in cash flow when it’s received.

Is Profit Useless?

Far from it. There is a reason why profit is one of the most important accounting terms used when it comes to measure financial performance. It certainly has it utility and accounting professionals will always use it because it is a key to calculate other metrics.

While profit can be a confusing and somewhat conceptual figure, it is still important. It is the first item necessary to use in calculating your cash flow. Cash flow, however, goes further by factoring in items that have a real effect on money coming in or going out of your business. That’s why cash flow is so important in driving growth and success.

In other words, the reason why cash flow is so important is because it is a metric that is entirely actionable for your financial decisions.

Need More Clarification on the Difference Between Profit and Cash Flow?

Are you looking to leverage your knowledge of your company’s financial position? Need help deciphering and interpreting the difference between profit and cash flow?

Schedule a call with Vertical CPA. Our accounting business focuses on startup businesses, providing accounting, tax and virtual CFO services. Let us help you get the most out of your hard-earned dollars. Schedule an initial call to get started.