A common mistake business owners make is confusing cash flow with profits.
Although cash flow and profit are related, they are not the same. Knowing what each means can give you a clearer insight into your company’s financial health.
Cash flow vs. profit: What’s the difference?
Cash flow refers to the money that flows in and out of a business, while profit is the surplus after deducting expenses from revenue.
You’ve probably noticed that your business financial accountbalance rarely equals your company’s actual profits.
There are main reasons for this:
- Timing: Profit reflects what your company has earned, not necessarily what it’s collected in cash yet. You may have sales made on credit (increasing your profit but not affecting your cash flow) or expensesyou’ve yet to pay (reducing your profit but not affecting your cash flow).
- Non-cash items: Profit includes accounting adjustments that don’t affect cash flow. Things like depreciation, amortization, and stock-based compensation all influence profits, but don’t involve cash.
Let’s look at some examples.
Transactions affecting profits, but not cash flow
Assume a jeweler sells a $5,000 engagement ring on June 1 and provides the buyer 12 months interest-free financing with the first payment due July 1.
The jeweler records the $5,000 as revenue on June 1. But records no cash inflow until July 1. The impact of this sale on the jeweler’s financial records for the next year looks like this:
| Date | Revenue Impact | Cash Flow Impact |
|---|---|---|
| June 1 | $5,000 | N/A |
| July 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| August 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| September 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| October 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| November 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| December 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| January 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| February 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| March 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| April 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| May 1 | N/A | + $416.67 ($5,000 ÷ 12) |
| June 1 | N/A | + $416.67 ($5,000 ÷ 12) |
Now assume the same jeweler needs to pay his salesperson a commission for selling the $5,000 engagement ring. The commission is 10% of the sales price and commission payments are made on the last day of the month.
The jeweler will record the commission expense on June 1 but won’t pay it until June 30. The impact on the financial records looks like this:
| Date | Expense Impact | Cash Flow Impact |
|---|---|---|
| June 1 | $500 ($5,000 x 10%) | N/A |
| June 30 | N/A | – $500 |
Transactions affecting cash flow, but not profits
Suppose an ecommerce lamp store keeps its inventory in a rented warehouse for $1,000 per month and is required to pay rent six months in advance. Rent payments are due on January 1 and July 1 each year.
The lamp store will pay out $6,000 on January 1, but only $1,000 is recorded as an expense on January 1. Remember expenses are recorded when incurred, not when paid.
The impact on the financial statements of prepaying the rent looks like this:
| Date | Expense Impact | Cash Flow Impact |
|---|---|---|
| January 1 | $1,000 ($6,000 ÷ 6) | – $6,000 |
| February 1 | $1,000 ($6,000 ÷ 6) | N/A |
| March 1 | $1,000 ($6,000 ÷ 6) | N/A |
| April 1 | $1,000 ($6,000 ÷ 6) | N/A |
| May 1 | $1,000 ($6,000 ÷ 6) | N/A |
| June 1 | $1,000 ($6,000 ÷ 6) | N/A |
What is cash flow?
Cash flow is the movement of cash into and out of a business. It can have positive cash flow (money in exceeds money out). Or it can have negative cash flow (money out exceeds money in).
A cash flow statement summarizes the cash a business generates and spends. The cash flow statement groups similar types of transactions together to provide business owners with meaningful insight into sources and uses of cash.
What are the types of cash flow?
There are three groups of cash flow that a business owner should know about. And these three types appear on a cash flow statement.
Operating cash flow
Operating activities are the regular, day-to-day financial functions of a company’s core business activity. They’re essential to generating revenue and keeping the business running.
Operating cash flow is the cash inflows and outflows related to the core business of a company.
Operating cash flow is an important indicator of a company’s financial health. It reveals the amount of money a business generated (or lost) from its core activity.
Let’s use Amazon’s Consolidated Statement of Cash Flow for December 31, 2023 as an example.
Remember that a company’s income statement will include non-cash expenses. And a cash flow statement reconciles a company’s income statement that includes non-cash expenses to actual cash movement.
Amazon’s cash flow statement starts with its net income figure (shown in the yellow boxes) from the income statement and makes adjustments for non-cash expenses such as depreciation, amortization, and stock-based compensation (shown in the purple boxes). This calculated adjusted net income is then further adjusted for changes in balance sheet items related to operating activities, including receivables, trade payables, and inventories (shown in the red boxes).
For the year ended December 31, 2023, Amazon’s core business operations generated $84.9 billion in operating cash flow (shown in the green box).
A business needs most of its cash flow to come from its core operating activity to be sustainable. These operating cash flows allow companies to make investments for growth and pay off debt.
Operating cash flow benchmarks vary by industry. Warning signs appear if 10% or less of your company’s cash flow comes from its operating activities consistently. This points to a bigger issue like selling unprofitable goods or services, relying too much on debt for cash inflow, or investing or growing at an unsustainable rate.
Investing cash flow
Investing cash flow, also called cash from investing activities, are cash inflows and outflows for items you hope will make you money in the future. It’s like planting seeds now with the goal of harvesting more cash later.
For example, when an ecommerce store buys new computers, purchases stocks or bonds to hold for investment gains, or works with a chemist to formulate a new vitamin supplement to add to its catalog, it’s making investments in its future cash inflows. This kind of cash outflow is called investing cash flow.
A company can also have cash inflow from investing activities. When it sells the computers or sells its stock or bond investments, it will have an investing cash inflow.
Let’s look again at Amazon’s cash flow statement for December 31, 2023.
The items in the blue boxes show that in 2023, Amazon’s investing activities included:
- Purchased property and equipment for $52.7 billion
- Sold property and equipment for $4.6 billion
- Purchased other businesses for $5.8 billion
- Sold some of its investments in the stock market for $5.6 billion
- Purchased investments in the stock market for $1.5 billion
Financing cash flow
Financing cash flow
Financing cash flows are all about the cash a company raises or uses to fund the growth and operations of a business. Businesses, including ecommerce stores, sometimes require external cash for a specific need.
External cash sources could come from SBA loans, lines of credits, or selling a portion of your company’s equity to an investor.
Businesses also use cash to repay lenders or distribute earnings to investors. These payments take the form of principal repayment, interest expense, or distributions to owners.
Let’s take one more look at Amazon’s December 31, 2023 cash flow statement.
The items in the orange boxes show that in 2023, Amazon’s financing activities included:
- Cash proceeds from issuing short-term debt was $18.1 billion
- Repayments of short-term debt totalled $25.7 billion
- Repayments on long-term debt were $3.7 billion
- Lease payments totalled $4.4 billion
- Repayment of other financing obligations was $271 million
What is profit?
Recall from earlier that profit is the surplus of revenue after deducting expenses. But if you have more expenses than revenue, you have a loss—not negative profit.
What are types of profit?
There are three different profits.
- Gross profit
- Operating profit
- Net profit
Gross profit
Gross profit is the amount a business earns exclusively from its primary business activity. It’s calculated as:
Gross profit = Net sales revenue – Cost of goods sold
- For resellers, gross profit is the net sales price minus the costs of the items purchased and resold.
- For manufacturers, gross profit is the net sales price less the costs of raw materials and manufacturing expenses for the products sold.
- For service-oriented businesses, gross profit is the net sales amount after deducting the direct costs related to the service provided.
To illustrate, consider a reseller that buys waffle makers at $10 and sells them at $30 each. Assume the business buys 20 waffle makers and sells all of them. Its revenue will be $600 (20 x $30), its cost of goods sold will be $200 (10 x $20), and its gross profit will be $400 ($600 – $200).
| Category | Amount |
|---|---|
| Sales | $600 |
| Cost of Goods Sold | ($200) |
| Gross Profit | $400 |
The gross profit amount shown above means the business is making $400 to pay for other expenses like marketing, administrative staff, and rent.
Operating profit
Operating profit is the next step in calculating profits. After gross profit, you want to look at operating profit.
Operating profit is what a business earns from its core activity after deducting all of its operating expenses and before considering taxes or other non-operational financial activities.
Operating expenses include things like:
- Salaries and wages
- Rent
- Utilities
- Marketing
- Bank fees
- Shipping and postage
- Software subscriptions
Let’s use Amazon’s December 31, 2023 Income Statement (they call it the Statement of Operations).
In the pink boxes you see Amazon had operating income (it’s the same thing as operating profit) of $36.9 billion for 2023.
Net profit
Net profit, also called net income, refers to the amount a business earns after deducting all business expenses, including cost of sales, operating expenses, interest expense, and taxes.
Net profit is a holistic view and shows the total profit a business has earned, whether from its core business or non-core business.
One last look at Amazon’s December 31, 2023 financial statements illustrates net profit.
The bottom of its Statement of Operations outlined in the blue boxes shows Amazon made a net profit (net income) of $30.4 billion in 2023.
Improve your cash flow and profits in 2024
Looking for ways to improve your company’s cash flow and profits? Give these suggestions some thought.
How to improve cash flow
- Liquidate stale inventory: Sell outdated or stale inventory for a discounted price. Consider wholesalers or resellers who might buy your old inventory in bulk.
- Expense reduction: Identify areas where you can cut expenses without compromising product quality or customer experience.
- Use financing wisely: Take advantage of proactive financing to grow and accelerate your business. But review your profits to ensure your company can afford the payments.
How to improve profit
- Review your pricing strategy: Analyze which products have higher margins and prioritize promoting or upselling those. Or create bundles of products to create higher margins.
- Consider dynamic pricing: Test dynamic pricing by adjusting prices based on demand, competitor pricing, or customer segments to get the maximum value while remaining competitive.
- Aim for efficiency: Automate repetitive tasks and invest in productivity tools to improve efficiency.
Cash flow vs profit FAQ
What is better cash flow or profit?
Both are necessary for a successful business. Ideally, you want both—positive cash flow and healthy profits. Start-up businesses should prioritize cash flow to establish themselves and secure investor funding.
Why is cash flow lower than profit?
Cash flow is typically lower than profit for companies that sell high-profit products on credit to customers. The business shows a profit on paper but may struggle to cover current expenses because of a cash shortage.
How can you be cash flow positive but not profitable?
You can be cash flow positive but not profitable from one-off, non-recurring items, like receiving loan proceeds or selling equity in your business for cash while having high expenses that contribute to your lack of profitability.
Is cash flow another term for profit?
No. Cash flow differs from profit. Cash flow is money in and money out of your business. Profit includes both cash and non-cash expenses in its calculation.
