Profits vs. Cash Flows: What’s the Difference and Why Does it Matter?
Understanding financial metrics and what they tell you is key to succeeding in business. Two of the most important are cash flows and profits.
On the surface, they sound similar. They both deal with you making money.
However, they look at your financial performance from slightly different angles. Thus, they both offer distinct sets of helpful information. Knowing the differences will help you make better decisions and avoid potential problems.
In this post, we’ll define profits and cash flows, review why each one is important, examine how they’re related, and explain why doing well with just one of them isn’t necessarily a good sign.
What Are Profits?
Profit — also called net income by some — is the money left over after handling your expenses. To calculate profits, simply subtract expenses from revenues.
Profits are the very last line on your income statement. Hence, people often refer to your profit number as the “bottom line.” You can have negative profits, too, called losses. These happen when your total expenses are greater than your revenues.
There’s another kind of profit called gross profits, but it’s simply the money left over after producing and distributing products. It doesn’t include administrative and other costs. For that reason, we’ll be discussing net profits throughout the rest of this article.
Why Are Profits Important?
It’s simple: your company cannot survive if it can’t stay profitable. Many small businesses show losses for a few years as they attempt to bootstrap their operations — and that’s fine. In fact, the IRS may let you write off a few years of losses to help you eventually become profitable.
However, that write-off doesn’t last forever, and you won’t either if you don’t start showing positive profits.
Once you’re profitable, you choose how you use those profits. Early-stage businesses often put most or all of their profits into retained earnings so they can reinvest in their business for more growth. As the business grows, the owner(s) can start paying out profits to themselves as distributions.
Lastly, profits can help you make adjustments to your business operations.
For example, revenue growth is nice, but your profits will stay the same if expenses increase alongside revenue. In that case, you might try to streamline things as you scale so more of your revenue turns into profit.
What Are Cash Flows?
Cash flows refer to the inflows and outflows of physical cash in your organization. Positive cash flows happen when cash inflows are greater than outflows, whereas negative cash flows result from the opposite.
There are three kinds of cash flows for financial reporting purposes:
- Operating cash flows: Cash flows that come from activities pertinent to your firm’s products or services. Cash inflows would come from product or service sales (where someone pays you cash, not on credit), whereas outflows would come from expenses like salaries/wages and buying inventory.
- Investing cash flows: Cash flows that come from any investment-related activities. Inflows might come from selling assets your firm holds (like a piece of machinery), whereas outflows could come from activities like research & development or purchasing securities.
- Financing cash flows: Cash flows that come from activities involved in funding the company. Taking out a business loan and issuing shares of stock can generate cash inflows from financing, whereas paying dividends and distributions would be cash outflows from financing.
Cash flows show up on the aptly named cash flow statement, which splits up your total cash flows into the above three categories.
Why Are Cash Flows Important?
Cash flows help you see if you physically have the cash available to meet your current and near-term obligations.
However, it’s deeper than that. You can derive a lot of insight by analyzing your types of cash flows.
For example, imagine you’re a clothing store. If you sell a machine you use to create the clothing, your cash flows might increase drastically… but you’re not a machine store. The cash flows you obtain from selling that equipment aren’t sustainable.
That’s precisely why cash flows are divided into three categories. This would be classified as cash flows from investment activities since you sold an asset (not part of your operations) rather than apparel (your operations).
How Profits and Cash Flows Interact
Under the accrual method of accounting, profits nor cash flows tell the whole story on their own. Highly profitable businesses can go under if they don’t have enough cash flows. Similarly, you could have excellent cash flows but fail to make any profits.
Let’s look at some examples to illustrate.
Great Profits, But Poor Cash Flows
Imagine you make $100,000 in sales this month, but they’re all on credit. No one sends you the physical funds. Meanwhile, you have $50,000 in regular monthly expenses, leaving a healthy $50,000 in profits this month.
But over the month, you receive payment for only $10,000 of the $100,000 in credit sales you made. In other words, you have $10,000 in cash flows this month.
Now, you only have $10,000 cash in the bank, despite selling $100,000 of products/services. However, you face $50,000 in expenses. You won’t be able to pay your vendors, suppliers, employees, creditors, and other parties despite showing profits that are 2x your expenses.
If you don’t have additional savings, you’re in big trouble.
In short: profits don’t matter if you don’t have the funds available to pay those expenses.
Great Cash Flows, But Poor Profits
Say you’re still in the early stages of business. You want to invest in new equipment to grow, but you don’t pay cash.
Instead, you take out a $20,000 loan to purchase the new equipment. This keeps your cash flows high because you’re not dropping cash on the equipment — instead, cash flows into your firm via the loan.
As a result, you have $20,000 in cash flows (assuming no other cash flows).
However, since your business is young and not making a ton of money yet, you might still post a net loss this year.
Keep in mind that your cash flows come from financing, not operations. Many businesses that see low profits but high cash flows generally receive most of those cash flows from financing (such as getting the loan) or investing (such as selling that equipment later). If you have positive cash flows, and most of your cash flows are coming from operations, then your profits mathematically must be positive as well.
Profits vs. Cash Flows: Is One Better Than the Other?
Neither one of these metrics is more important than the other. Although they’re related, they serve different purposes.
In general, profits indicate overall business success. They let you and any other interested parties know if you’re growing over time. Meanwhile, positive cash flows are vital to maintaining your day-to-day operations.
Therefore, you should keep a handle on both — and that’s something accounting software like ZarMoney can help out with. With ZarMoney, you can generate financial reports that show you both of these and other vital financial metrics so you can make better business decisions. Try ZarMoney for free today.