Difference Between Profit and Cash Flow
Profit and cash flow are two important metrics in financial accounting and they each measure different aspects of a company’s financial health. Here’s how they differ:
Profit:
Profit, also known as net income, is the amount that remains from revenues after all expenses have been subtracted. It is a measure of the overall profitability of a business during a specific period. Profit is calculated using the accrual basis of accounting, which matches revenues with the expenses incurred in earning them, regardless of when cash changes hands.
For example, if a company sells a product but hasn’t yet received payment, the sale will still be recorded as revenue, increasing the company’s profit. Conversely, if a company incurs an expense but hasn’t yet paid cash for it, that expense will be recorded and reduce the company’s profit.
Cash Flow:
Cash flow, on the other hand, represents the actual inflow and outflow of cash within a business over a specific period. It shows how much cash a company is generating and where that cash is coming from. There are three types of cash flows:
- Operating Cash Flow: This represents the cash generated from a company’s core business operations. It reflects how much cash the company generates from selling its products or services.
- Investing Cash Flow: This reflects cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or long-term assets.
- Financing Cash Flow: This shows cash generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends.
A company can have positive net income (profit) but still run into trouble if its operations do not generate enough cash to sustain the business, a situation sometimes summarized as “profit is an opinion, but cash is a fact.” For example, a company might be profitable on paper, but if its customers are slow to pay their invoices, the company could face a cash crunch.
In conclusion, while both profit and cash flow provide valuable insights into a company’s financial health, they serve different purposes and are used in different ways by investors and management. Understanding the difference between the two is key to comprehending a company’s financial statements and its overall financial health.
Example of the Difference Between Profit and Cash Flow
Let’s use a hypothetical example of a small business that sells handmade furniture, called “Handcraft Furniture Co.”
Profit Example:
In the first quarter of the year, Handcraft Furniture Co. sells $50,000 worth of furniture. The cost of materials and labor to produce the furniture comes to $20,000, and they have additional operating expenses of $10,000 (rent, utilities, office supplies, etc.). The profit for the first quarter would be:
Revenue ($50,000) – Cost of goods sold ($20,000) – Operating expenses ($10,000) = $20,000
So, Handcraft Furniture Co. has made a profit of $20,000 in the first quarter.
Cash Flow Example:
Now, let’s look at Handcraft Furniture Co.’s cash flow for the first quarter. Let’s say $30,000 of the furniture sales were made on credit and will be collected in the second quarter. So, actual cash received from customers in the first quarter is only $20,000.
Let’s also assume they paid $15,000 in cash for materials and labor and $10,000 for operating expenses. Additionally, they made a loan payment of $5,000 and invested $3,000 in new equipment. The cash flow for the first quarter would be:
Cash received from customers ($20,000) – Cash paid for costs of goods sold ($15,000) – Operating expenses ($10,000) – Loan payment ($5,000) – Investment in equipment ($3,000) = -$13,000
So, even though Handcraft Furniture Co. showed a profit of $20,000 for the first quarter, their cash flow was negative by $13,000 because much of their sales are yet to be collected, and they made significant loan payments and equipment investments.
This demonstrates the key difference between profit and cash flow. A company can be profitable but still run into financial trouble if it doesn’t manage its cash flow effectively.
