Cashflow vs Profit – what is the difference?
Navigating accounting terminology can be difficult. Jim Vass from ATB Chartered Accountants explains the importance of two key metrics… profit and cash flow.
Jim, understanding profit is important – there’s no point in working if you’re not making a profit right?
“That’s right. Put simply, profit is income earned by a business through providing goods and services. Expenses are costs associated with earning the business income. Profit is what is left after you take your expenses from income.
The issue is that just because the business is making a profit, it doesn’t mean that people are taking money home. They might go in to business and make a profit, but if they don’t control the cashflow, they might take less home than they did when they were employed.
Profit is a useful measure to determine how a business has traded within a specified period. Comparison of income, expenses and profit between your business and other similar businesses provide insight as to how your business is performing. And profit is also a good indicator to be able to determine how much tax you will need to pay.”
But if I’m profitable where is the money?
“Whereas profit determines how much tax needs to be paid, cashflow ensures that funds are available to pay taxes and other items when they are due.
Cashflow is money flowing in and out of a business. It also includes amounts applied to reduction of debt and purchase of assets.”
What is it about cashflow that can mean there’s no money in the bank?
“Poor cashflow doesn’t necessarily mean poor profit. It can result from the acquisition of assets, a quick reduction of debt, a business owner’s personal spending being to high, or inadequate working capital.
Cashflow is different for many businesses so it is important to understand how the cashflow of a business works. For example a café would receive the bulk of its income at the time of sale, whereas a manufacturer would incur a large amount of costs to produce a product prior to any sale being made.
Some people don’t consider how money goes in and out of a business. Cashflow is a sale today that counts towards profit, but when do you see the money for that sale? You may have parted with money for something you sell to a client a month later. That will be a hole in your cashflow.”
These cash flow holes could grow as a business scales?
“Absolutely. As a sole trader for example, you only have to worry about yourself. But when you put on more people you have additional expenses requiring cashflow to support their pay and obligations. That’s when you can get big problems.”
Is that a reason people go out of business?
“Yes. People are often not aware of what working capital is required to keep a business going and meet all expenses on an ongoing basis to match up with what’s happening in the business.”
What can be done to manage cashflow?
“The most critical thing is to have a well-prepared budget to assist with identifying what the business owner intends to achieve during the next twelve months. We at least aim for a 12 month budget.
It’s not about restricting spending, it’s about looking at who your clients are, what your targets are, your revenue and income generated…
A budget should not only consider profit, it should also consider the flow of cash in and out of the business. This will highlight when any potential problems will occur and allow you to plan on how to address them. These problems include a blow out in expenses, income targets not being met and resulting cashflow requirements.
Business performance needs to be constantly compared and measured against the budget in order to make adjustments during the year to help you achieve your business goals.
Some people just increase their budget by 5% without much thought. But it’s better to sit down and review your core clients, and what activities are going to generate extra business. You need to review if your resources are adequate to meet the demand. When is that additional cost coming in? What’s my baseline? When am I doing these activities? When do I need additional staff or computers or equipment?
In planning, you might come out with a profit loss, and the outcome might not deliver what you want. So it’s better to look 12 months down the track and look at what you need to change now or throughout the year to achieve that your goals. It’s easier to get an overdraft when you don’t need it than when you do!”
How else can you keep on top of cashflow?
“It’s one of those things people can be too busy to think about. But you can manage the way you invoice for example. If you invoice 2 weeks after the job, you’ll be waiting another 30 days for payment, carrying the cost of the job. On the flip side is collection of money – often people are invoicing but are too busy to collect. It’s important to keep an eye on what’s coming in and what you’re spending. Collection and invoicing have to happen quickly. It’s better to have the money in your account!”
Which is more important, cashflow or profit?
“Both are important; however, it is cashflow that will allow a business to continue to operate, at least in the short term. If a business is not profitable eventually the cashflow will dry up and the business will fail.”
How do ATB work with clients to manage this?
“We work with clients on their budget, cashflow, and their projected balance sheet. Once a budget is done and prepared, you have to keep measuring it.
I once heard a speaker say that a pilot takes off from Sydney to England, they don’t just see that as a straight line. They constantly monitor where they’re going, measuring and adjusting to keep them on course. A business is no different. If you know where you want to get to in 12 months time, monitor and measure constantly and you will get there.
So it’s a about setting a target and constantly working towards it. And it’s also about concentrating on looking inwards at your business as well as providing a service.”
Want to know more about cashflow and profit? Contact us we’re here to help.