The difference between cash flow and profits
Updated: Aug 1, 2020
The most important thing to know about cash flow is that it isn’t the same as profits. Profits and cash aren’t the same thing.
Here’s a quick explanation:
When you sell a product to a customer and send that customer an invoice, you often don’t get paid right away. Instead, you get paid in 30 days, maybe more. When you make this sale, however, you will show that sale on your profit and loss statement, which will help you calculate profits.
But, this sale won’t show up in your cash flow until you actually get the money from your customer. You track sales that you’ve made but haven’t been paid for yet with accounts receivable.
Why is cash flow important?
At the most basic level, you need to understand and analyze your cash flow so that you know if your business bank accounts are growing or shrinking over time.
After all, you can’t run out of cash. If you do, you’re headed for bankruptcy.
Forecasting your cash flow is critical for running a healthy business. You’ll want to know how much cash you need to keep on hand to pay your bills You can also use a cash flow forecast to figure out when the best time will be to buy new equipment or when you can buy more inventory. With a cash flow forecast, you will even be able to see how fast growth can actually hurt your cash position.
Fast growth can be bad for your bank account (really?!?)
That’s right; fast growth can actually put your business in a challenging cash situation. That seems odd, but it’s true—especially for businesses that invoice their customers and get paid after they deliver their products.
So, how does this happen? Think about a business that sells widgets. In order to sell the widgets, the business needs to buy the materials for the widgets, pay employees to put the widgets together and package them, and finally ship them to the customer.
This business has paid for the widgets, paid salaries, and even paid shipping at this point, but the customer hasn’t paid yet. Since the customer’s invoice says “net-30” on the top of it, the customer might take up to 30 days to pay the bill. The business has paid out cash to deliver their widgets but won’t receive cash payments until much later.
If your business is growing and large orders are coming in quickly, you will most likely need to have a good amount of cash in your bank accounts to fulfill orders and support this growth.
What’s better? Positive or negative cash flow?
Positive cash flow is almost always better. This means that you are bringing money in the doors and accumulating cash that you can later invest in the business.
However, there are cases where a business may be expected to have negative cash flow. New startup companies and companies that are investing heavily in growth will often have negative cash flow.
Startups need to build their products, invest in initial marketing, and pay salaries before the first customer payments start rolling in. Companies that are investing in growth might have negative cash flow as they buy new equipment or expand their operations. These companies are hoping that their investment now will pay off with more customers and more cash coming into the business over the long term.