Profit is Not the Same as Cash Flow!

Jan 08, 2024 by Roger Scherping



It simply never occurs to many small business owners that there is a difference between profit and cash flow. Many owners subconsciously think of them as the same. They just assume that if they make a large profit, then they will have lots of cash in the bank.

Sadly, this is often not true. In fact, this is one of the most common misconceptions by business owners that I’ve seen in my career. I’m sure you’ve seen that with your clients, too, and you’ve done your best to educate them on the difference between profit and cash flow.

One small business owner I know said it best: “There have been many years where I made lots of money, but I was broke.”

How do you explain the difference between profit and cash flow to your clients? Hopefully the following will help.


Profit vs. Cash Flow Primer
                     
Profit is the increase in equity value for your business. It’s sort of like how much more your business is “worth.” Your accountant determines your profit through a complex process involving invoices, bills, accruals, assumptions, methods, estimates, and esoteric topics like depreciation and amortization.

Cash is much easier to understand: “How much is in my bank account?” That’s simply a function of how much cash you took in and how much you paid out.

I have a difficult time explaining the difference between the two to my clients. They often seem to think that at the end of the month the amount of their profit will somehow be deposited into their bank account for them to spend. Or they blur the line between the two by taking their profit or loss and deducting things like debt payments to get to what they consider their cash flow for the month.

The reason why profit is often so different from cash flow is that there are many ways you spend money that don’t decrease your profit. For example, making payments on a loan reduces your cash but not your profits. So does spending cash on a new piece of equipment, and the owner taking a cash distribution out of the business.

Even worse are the small business owners who think that if they SELL a lot, then they'll have lots of cash. Your cash flow is driven by your PROFITS, not your sales. You've got to make a profit on what you sell to have positive cash flow.

Do you see now that profit and cash flow are different? Let’s take a closer look.


Cash Flow Explained

As I said earlier, accountants calculate profit using what we call generally accepted accounting principles, and profit is driven by making profitable sales and minimizing your overhead costs.

But what about cash flow? What drives your cash flow? It starts with profit, of course, and we can explain what happens from there by asking a few questions.

-- Do you collect all of your sales every month? If you sell online you probably do. Or do you instead invoice your customers and wait for them to pay you? If so, your cash flow – but not your profit – is impacted by the length of time it takes you to get paid.

-- It’s the opposite for your vendors. Do you pay your vendors immediately, or do they bill you? If they bill you, then your cash flow – but not your profit – will be impacted by how slowly or quickly you pay your vendors. In my experience, delaying payments to your vendors is one of the most common ways to improve your cash flow, although you can’t rely on that tactic indefinitely! Bill paying is a difficult one for lots of business people to understand. They think that if we don’t have to pay a bill immediately, then it won’t affect our profit. But most companies use the accrual basis of accounting, so when you pay the bill doesn’t matter. What matters is when you incur the cost.

-- Do you have any customers that pay you a retainer for services you will provide to them in future months? If so, congratulations. One of the best ways to finance your business is with OPM (Other People’s Money). The months in which you receive those retainers will have a positive cash flow impact far greater than the impact on that month’s profit.

-- Do you make annual or semi-annual payments for things like real estate taxes or insurance? Those payments will have a negative cash flow impact in the months when the payments are made.

-- Do you have any debts? Debt payments reduce your cash but have no impact on your profit (assuming you already properly accounted for the interest portion).

-- Do you ever take a cash distribution from your business? If the owner takes money out of their business as a distribution (not a salary), then that will negatively impact their cash flow but have no impact on their profit.

Get the idea now? There are lots of reasons why cash flow is not the same as profit.


Reporting Cash Flow

So, you can’t just think that if you make lots of sales or a good profit then cash will take care of itself. You can understand now that you have to pay attention to both profit and cash flow to be successful. You should be looking at both every month when you review your numbers.

Fortunately, there is a standard financial statement that does nothing but explain the difference between profit and cash flow. It starts with profit for the month and then takes into account all of the factors mentioned above (and others) and adds or subtracts them in order to get to your net cash flow for the month.

This standard financial statement is called the Statement of Cash Flows, and unfortunately, it is the most underutilized of all of the financial statements. If more small businesses would pay as much attention to their Statement of Cash Flows as they do to their Income Statement, they would be much better off. They would understand what factors are impacting their cash flow and learn which ones they can impact to improve their cash flow.


Trusted Advisors: Do a Prediction

If you add a monthly prediction prepared with ProjectionSmart to the services you provide your clients every month, you will quickly and easily turn your client’s backwards-looking financial statements into a forward-looking prediction. ProjectionSmart is a powerful tool, and a key part of the prediction is the look-ahead you give your clients as to their upcoming cash flow because one of ProjectionSmart’s standard forward-looking reports is a Projected Statement of Cash Flows for the next 12 months.

ProjectionSmart also does a great job of helping you explain cash flow to your clients. We’ve found that our simple online tool is much easier to understand than a multi-tab spreadsheet in which they often get lost. All of our reports will be clear to your client because the reports are created using numbers that your client determined. Your client can also see where the numbers appear in the Statement of Cash Flows and clearly understand how these numbers impact their cash flow. This gives them real insight into their cash flow and helps them see where they can make changes that positively impact their cash flow.
                                                           

ProjectionSmart Benefits for the Trusted Advisor
                   
The ProjectionSmart process is quick and simple. We’ve done all of the hard work for you and put it into an online tool. When you use ProjectionSmart, maybe you are able to bill for an additional hour each month to create their prediction, or maybe you bill them an additional fee for their prediction. It’s up to you.
                                                
When you do a monthly prediction with your clients, they will be more successful and more comfortable with their numbers. They will be anticipate and avoid problems, leverage resources more effectively, make more quantitative business decisions, and feel much better about their business’s future – all because of you!

On your side, you will increase your monthly revenue, have happier and longer-term clients, help your clients be more successful, and differentiate your practice.
                                         
After all, who doesn’t want happier and more successful clients and more revenue? Let us help.

Here’s a video to show you how easy ProjectionSmart is to use.                                                                               
                                                                                                                       
Try out the new ProjectionSmart here.

 

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