Understanding the difference between business cash flow and profits or net income can mean the difference between success and failure for your business. Profits look good in your business reports and they can help you get financing, but cash flow can be more important in keeping your business going in tough times.
This article will explore the concepts of profit and cash flow, the part they play in a business for accounting and tax purposes, and when each one is most important.
- Cash flow is the day-to-day flow of cash in your business checking account and other sources of quick cash.
- Business profits are your business income minus your business expenses on an accounting statement and on your tax return.
- The main difference between these two concepts is that profits include some types of non-cash expenses.
- Cash flow is important when starting a business and in times of low sales.
- Profits are important in convincing lenders and investors of the long-term viability of your business.
Business Profits and Net Income
Profits and net income are often confused. They basically mean the same thing, but in different contexts for your business. Profits are an accounting statement that shows the result of subtracting expenses from the income of a business. For example, if a business has an income for the year of $50,000 and expenses of $30,000, the business has a profit of $20,000.
A business reports its profits on a profit and loss (P&L) statement (sometimes called an income statement), showing the income and expenses of the business over a period of time.
Net income is calculated in a similar way to profits by starting with the business gross income and subtracting various kinds of expenses to get a total net income amount. The Internal Revenue Service (IRS) uses the term "net income" in business tax returns.
For example, a sole proprietor can calculate the net income of their business on Schedule C as part of the owner's personal tax return. Then, the net income calculation is included on the owner's personal tax return Form 1040/1040-SR along with all the rest of the business owner's income.
Cash and Cash Flow
Cash means cash on hand, an asset owned by a business that has value because it can be used to pay expenses without delay. Types of cash are your business checking, savings, money market account, and other types you can use immediately for payments.
Some other types of business assets are called "cash equivalents" because they can be converted quickly to cash to pay bills. The most common types are accounts receivable (money owed by customers), marketable securities (stocks and bonds), and inventory.
Cash flow refers to the movement of money into and out of your business, usually through your business checking account. If the net cash flow is positive (more cash coming in than going out), that's good for your business. If it's negative, however, it means your business is spending more than it's collecting from customers.
Businesses track and report their cash flow over a year in a cash flow statement. The statement begins with cash and cash equivalents at the beginning of the year and ends with this amount at the end of the year.
The types of activities of cash going in and out during the year are:
- Changes in operating activities including like cash from customer payments, cash payments for bills, depreciation and amortization on major assets, and changes in the value of other assets
- Cash in and out from investments
- Cash in and out from financing
The result is the change in cash and cash equivalents for the year.
How Cash Flow and Profits Work
To understand the difference between cash flow and profits, let's take a hypothetical look at the activity in a business bank account. There is $3,000 in your bank account from sales this month and previous months. You need to pay rent on your office space of $1,100. You also need to pay utilities ($220) and the freelancer who helped you with the web design project ($850). That takes $2,170 out of your business bank account, leaving $830.
This month is the end of a quarter. Your profit for the quarter on your profit and loss statement is $5,200. But even though you made a profit, you can't take out more than $830 to pay yourself as the business owner because you don't have enough cash.
Accounts Affecting Profits But Not Cash Flow
Cash flows show the liquidity of a business. Liquidity is the availability of money for spending and investment. Profitability, meanwhile, shows the income versus expenses of your business, and some of these expenses aren't spent in cash. Here are some examples:
Depreciation is a non-cash expense of your business. It's an accounting concept that reduces the value of depreciable assets for a profit and loss statement, so it affects your business profits but not your cash flow.
Inventory and cost of goods sold also affect profits, but not necessarily cash because of the timing of the expenses. For example, you may have bought products to put into inventory including products you haven't yet sold.
Iowa State University's Business Extension and Development Department offers a detailed analysis of how different types of business transactions affect profits versus cash flow.
Accounting Methods for Cash Flow and Profits
Businesses can use one of two accounting methods—cash and accrual. In cash accounting, you deduct business expenses and add business income in the year it was received or paid. In accrual accounting, though, income is received when the bill or invoice is sent and bills must be recognized when received.
In accrual accounting, your cash flow and your profits are two different things, especially at the end of the year. For example, let's say you sent a client an invoice for $3,100 on December 15 and the client didn't pay you until January. You now have a sale of $3,100 on your P&L statement, but the money isn't in the bank—meaning no cash yet. The income is recognized for the year on your P&L statement.
In the same way, if you receive a bill for $8,000 at the end of the year and you don't pay it until January, you can put the expense on your tax statement for the year, even if your cash flow statement wouldn't include it.
Which Is More Important - Profits or Cash Flow?
Both profits and cash are important to businesses for different reasons.
It's possible to show a profit and have a negative cash flow. It's also possible to have a positive cash flow and increasing sales but not make a profit.
For a small business just starting out, the saying is that "cash flow is king." If your income from customers isn't enough to pay your bills, your business may close before you make a profit. This is why startup businesses are the riskiest for lenders.
Managing cash flow is important at any point in the life of your business. For example, if you don't have an emergency supply of ready cash, you will quickly have a problem in a disaster situation like the pandemic, when customers stopped coming in.
In the long run, a record of profitability will show potential investors and lenders that your business is viable, and able to grow, survive in the long term.