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, 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, 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.”
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.