It’s the age-old debate: cash flow or profit? The two are related. But they are not the same thing, and business owners often need to sacrifice one in the short term. In the long term, a business needs both positive cash flow and profits to continue trading. But which one should entrepreneurs prioritise? Some say that “cash is king” whilst others argue that “profit is everything,” but what is the truth? Let’s take a closer look and find out.
What is Cash Flow?
Cash flow is the money flowing in and out of a business. It refers to available funds rather than money tied up in uncollected profits or hard assets. A business needs cash to continue operations. Without cash, the owner cannot pay suppliers, staff, and utility bills. Or buy inventory. If your business was a car, then cash flow would be the fuel in the tank – you can’t move forward without it.
There are three main types of cash flow:
- Operating cash flow. The amount of cash generated from regular business operations, such as sales.
- Investing cash flow. Cash earned from investments, such as securities, property, or the sale of assets. During a period when your business is investing, this number may be negative. But it will become positive when these investments begin to generate a return.
- Financing cash flow. The net cash generated to finance the company, including debt and dividend payments.
Positive cash flow means that more cash is coming in than going out. Your business’ liquid assets are increasing. Negative cash flow means the opposite.
It’s normal to experience a short period of negative cash flow when you are investing in growth. This happens because you must first spend money to generate more liquid assets in the future. But, a sustained period of negative cash flow means that your business is running out of fuel. When this happens you need to take action.
What is Profit?
In a nutshell, profit = revenue – expenses. It’s how much money remains in your business after you deduct expenses from your total turnover. Again, there are three main types of profit:
- Gross profit = revenue – cost of goods sold. This includes variable costs such as materials and labour, but not fixed costs such as rent.
- Operating profit = revenue – business costs. This figure includes fixed costs but excludes tax, interest payments on debt, and income from investments. These are outside the realm of the core business.
- Net profit = revenue – all expenses, including tax and interest.
It’s important to understand the difference between these three figures. This will help you understand which costs have the biggest impact on your net profit.
Which is More Important?
Both cash flow and profit are important to the long-term success of a business. But in the short term, it may be prudent to prioritise one over the other. It’s possible to be in profit and yet run out of cash, and vice versa. Both matter, but which matters most depends on your current financial situation.
For example, a business may make a profit each month. But if that money is tied up in assets then it may be unable to pay employees and suppliers. In this situation, it will have to stop trading. In this instance, the business should prioritise cash flow.
But, a business may have a healthy cash flow but fail to make a profit due to excessive debt. Here, it may be prudent to prioritise paying off to order to become profitable.
Failing to generate a profit over a sustained period of time will harm cash flow. It’s important to balance cash flow and profit. But this can be difficult to do – especially when you’re a busy business owner with a lot on your plate. For this reason, it’s worth investing in a qualified accountant. He or she will help you to maintain a healthy cash flow whilst generating a profit without losing your mind in the process.