#21: Understand the Difference Between Cash Flow and Profit

Don’t mistake profits for cash flow, because they are not the same thing!! That’s the focus in today’s episode. There is a difference between profit and cash flow and you need to know about it. After a recent poll on our Facebook page, we discovered cash flow is a topic you are interested in learning more about, so we are delivering that to you over the next couple of weeks!

What we cover in this episode:

1:00 – Intro
8:35 – What is the difference between profit vs. cash flow?
11:36 – Implications of cash flow issues in your business
15:00 – Real world example: How cash flow and profit differ
21:00 – Best practices for cash flow continuity
26:44 – What can you do to monitor cash flow properly

What is the difference between profit vs. cash flow?

Profit is your income or your gross revenue you’re bringing in minus all of your expenses and cost of goods sold. It’s what’s leftover at the end. Cash flow focuses more on the movement of money within your business. Simply put, it is cash coming in and cash going out.

It is common for business owners to show a profit and then say “where did that money go?” Your business could show a profit on financial statements, but issues can arise if you don’t monitor the inflows and outflows of cash as your business operates. You may even end up with negative cash flow, which happens when a business spends more money than it makes during a specific period of time. This is obviously unsustainable if you continually don’t have enough to cover operating expenses. Over time, unobserved negative cash flow can mean your business is unprofitable.

Cash flow looks different depending on the type of industry you’re in and what type of business you operate. You could be a manufacturer with many hard costs associated with your revenue. That contrasts with someone who is service-based, in which there may be no physical product but instead it’s your time. So the question then becomes, how and when do you collect your revenue? Do you collect the total amount upfront? Do you require a deposit or half upfront and half at the end? When you collect it, are you recognizing it as revenue? We are going to discuss different ways to collect to cover the costs that it takes to complete a contract. From a timing perspective, it’s very important to ensure you have enough cash to cover expenses and understand the timing that it’s coming in.

Implications of cash flow issues in your business

According to SCORE, 82% of small businesses fail because of cash flow issues. That is a shocking statistic that can honestly be scary and intimidating. There is a reason it’s one of the largest reasons businesses fail – It’s time consuming. It takes work. People don’t want to pay for it and don’t want to take time to do it themselves. If you’re not on top of it for your business, then you end up reacting to situations rather than seeing it come down the pipeline.

If your business isn’t one of the statistics above, cash flow issues can slow down the growth rate of your business. If you don’t have access to the proper cash, your options become much more limited and possibilities and innovation can be stifled. Check out episode #22, where we discuss direct and indirect cash flow statements and how to take control of your current cash flow situation.

Cash flow issues can also lead to less freedom and more stress. We don’t just carry the stress of our own issues. We carry the stress of our customers, our vendors, our employees, our families, etc. While this doesn’t mean you need an endless amount of cash in the bank, it does limit the actions you can take if you are tied down by cash flow issues. When you’re responsible and accountable to a lot of other parties, as many business owners are, it can break you down as an individual. We want to avoid those stressful breakdowns by empowering you to take control.

Real-world example: How cash flow differs from profit

Let’s break down the real-world application of this difference. We have the definitions above but how would cash flow potentially have a different impact on your life and your business than

Whenever you have a long-term liability, such as a line of credit, mortgage or other long-term debt, you usually have a payment and amortization schedule. The payments break down to a principal portion and an interest portion.

For the sake of simplicity in this example, we are starting with $10,000 in revenue. Now, we are going to take on a mortgage on a business property that costs us $1,000 every month, $500 of that is toward principal and $500 will go toward interest. So, that means:

$500 each month is paying down your liability of your mortgage.
$500 each month is paying the interest, which is deductible.

So, your cash flow hit is $1,000 per month, or $12,000 annually. Now, let’s come back to your $10,000 revenue. Upon first look, you may be thinking $10,000 revenue minus the $12,000 in payments equals -$2,000 (a loss). But that would be wrong. You aren’t taking $12,000 as a deduction because only half of that was deductible. The other half was used to pay down your liability. So in reality, in this very simplified example, you would take your $10,000 revenue minus $6,000 in deductions, and report $4,000 of income for tax purposes. Again, in reality this discussion is happening with your tax professional and there are obviously other factors that go into determining taxable income, but we wanted to highlight that difference.

Bottom line is, there is anxiety when you have many unknowns. There are tax planning sessions that can really reduce that amount of stress and give you peace of mind in knowing where you stand. The CPA you work with should be able to offer some type of tax planning opportunity so you feel more sure about where you stand.

Best practices for cash flow continuity

Manage the credit you give to your customers.

Putting a consistent policy in place for all customers when it comes to giving credit will help reduce the amount of time and effort needed to manage the process. Establish effective reporting so you know who owes you and how much they owe you. If you don’t have the time to monitor those reports, delegate this task to someone who will manage it for you. There are strategies you can implement to encourage faster payment as well. You can offer a 2% discount if they pay in the first 10 days. Or you can implement a policy in which payment must be received before services are delivered.

Keep your books up-to-date.

If you don’t have your books up to date, your data is useless. If you are struggling with cash flow, you need your books to be timely in order to do anything about it. Sometimes as CPAs, we hear “I can’t afford it” but we argue that you can’t afford NOT to. Having accurate information allows you to be more proactive and saves you the stress of cash shortfalls. Understand the importance of having these reports and utilize that information.

Contingency plans for borrowing are crucial.

This is your safety net. Typically, a plan B for a business is a line of credit. In a pinch, a credit card may act as your plan B as well, but pay attention to interest rates because that can get out of control quickly as well. Establishing a line of credit just in case you need to tap into it will allow you to continue business operations even if you pay it back within a few weeks.

Manage your bill payment schedule.

Effectively managing your accounts payable is another important component of the cash flow picture. If you pay everything right when it comes in, when you could have waited another 20 days, and you run into a cash flow issue, this can get you into trouble. Pay attention to due dates and hold off on paying if you can to make sure it meets your cash flow needs.

Fund your business properly.

Take a look at how you’re funding your business. Is it with your own cash, investors cash, or possibly bank loans? Make sure the terms work well with your business. There are loans available that change interest rates or can cause havoc by calling on interest in 2 years. Be careful signing an on demand note as well. If an investor is able to call on that money in 1.5 years and you won’t have the cash to do that, your business may come to an end. It’s important to consider these things when looking at lending and be careful to setup the right parameters to protect your business.

Manage your inventory.

You want to have enough inventory, but try to avoid waste. It’s no fun carrying items you’re just trying to get your money back on. There are inventory management systems that will alert you if something gets below a certain threshold that can help manage this part of the business.

What can you do to monitor cash flow properly?

We are coming back to starting with accurate, timely data. Once you know you are working with up-to-date information, ask questions and be proactive. If you’re going to have a cash flow hit, plan for that the best you can. Dig in and gain an understanding of when cash is coming in vs. when your expenses are hitting. It’s nearly impossible to get it perfect, but putting together a cash flow budget can be a huge help.

In addition, surrounding yourself with the proper advisory staff AND leveraging those relationships can mean the difference between success and failure. Having that information can shield you from further pitfalls. Your advisory team should be able to help you build relationships and assist you in putting safety nets in place to protect yourself and your business. If you underestimate or overestimate and need cash, you shouldn’t be depending on that personally. Surround yourself with the right contacts and the right financial tools to avoid those pitfalls.

Conclusion

We talked about profits vs. cash flow in today’s episode, starting with a definition of both terms. We then talked about the implications of cash flow issues, noting the staggering statistic from SCORE that 82% of small businesses fail because of cash flow issues. There are other implications like slowed growth, increased stress and lessened freedom as well.

We then break down a real-world example. While this is a very simplified example, we run through how cash flow and a profit you may show would differ when it comes to how taxes are reported at the end of the year.

After talking about the challenges business owners can face with cash flow issues, we break down some best practices for cash flow continuity. Tips like managing credit given to clients, keeping books up-to-date and more, create the big picture of cash flow within your business operations.

We wrap up by talking about steps you can take to monitor cash flow more effectively. In addition to a foundation of accurate data, things like asking questions and being proactive can give you a better sense of ownership rather than avoiding the topics of cash flow because you may not want to address it. Surrounding yourself with the right professionals, mentors and advisors can make a world of difference as well because they will be helping to shield your business and keep your best interest at heart, to ultimately help you succeed.