Is Cash Flow More Important Than Profit?
A very common mistake for small business owners is to focus solely on profits, neglecting the importance of cash flow. Cash flow is vital for keeping the financial side of a business healthy. Without it, you are limited in what you can do to keep your business operating successfully.
So, what is cash flow exactly? Why is it so crucial for a business? Here’s everything you need to know.
What is the Definition of Cash Flow?
Cash flow is the money that flows in and out of a business. It is what a business utilizes for the daily running costs, such as purchasing inventory, paying staff, taxes, rent, and utilities. Having a positive cash flow shows that a company is “liquid”, because you’re earning more than you’re spending. Therefore, it can increase its assets.
A positive cash flow also shows that a business can pay out to shareholders, pay expenses and debts, and also have cash in reserve to cover unforeseen events.
If a business’s cash flow is negative, then it shows the opposite of the above. Decreasing liquidity means the inability to pay for obligated expenses, bills, and invoices.
How is Cash Flow Calculated?
- Free cash flow: The most common and important method shows you how much cash you have on hand at a given point in time. Calculation: Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure
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Operating cash flow: This gives a more in-depth, accurate picture of your cash flow because it incorporates irregular and one-off expenditures. If you're looking to secure outside investment, this is the type of calculation you need.
Calculation: Operating Income + Depreciation – Taxes + Change in Working Capital -
Cash flow interest: Used for future planning. This formula calculates your projected cash flow for an upcoming time period (monthly, quarterly, etc.).
Calculation: Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash
Which Factors Affect Cash Flow?
- Accounts receivables: This is the money owed to a business after rendering services or products. In other words, it's the in-flow of cash. However, customers that haven't settled their bills or have outstanding payments can cause cash flow disruptions. These outstanding receivables can mean there is not enough cash on hand to pay for expenses.
- Large investments: While investing in your business is good, it can also seriously affect your cash flow. A large purchase will greatly diminish your available cash flow and leave you struggling in other areas.
- Market environment: The state of the market directly impacts a business’s ability to invest or finance. If the market is bad, you may not be able to get the cash injection you need to move forward.
- Payment hold-ups: While your customer may pay their invoice before the due date, the actual processing time of this payment can take a while. In some cases, it can take up to a month, seriously hindering cash flow.
What are the Benefits of Positive Cash Flow?
Having a positive cash flow statement allows you to meet the financial obligations of the business without going into the red or having to borrow money. It also gives you the buffer zone required should anything unexpected happen. For example, if a piece of vital machinery breaks, having the cash flow to pay for the repair will mean you’re back in business asap.
A positive cash flow report also improves your credit rating. This is good news if you require outside investment or credit at some point. Positive cash flow also improves your ability to expand and scale your business.
What is the Definition of Profit?
Profit is one of the key factors that determine a business’s success. It is defined as the amount that remains after all outgoing expenses have been fulfilled. For example, if your business generates $20,000 in sales but it costs $15,000 to generate that $20,000, it means your profit is only $5,000.
Profit gives the overall picture of your business and is the amount used on which to base your taxes.
How is Profit Calculated?
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Gross profit: This is the profit made after the cost of purchasing goods has been subtracted. This figure is important for determining the profitability and financial performance of the company.
Calculation: Total revenue – COGS (cost of goods sold) -
Net Profit: This is the profit earned after ALL operating costs, taxes, and expenses have been deducted. To understand the net profit, you must first determine the gross profit. Net profit shows you exactly how profitable the business is, as well as if you have enough overall profit to grow and expand.
Calculation: Total revenue – total expenses
Why Profit Isn't Always the Most Important Metric
While profit is crucial to creating cash flow within your business, it doesn’t determine the amount of cash flow available. Profits are susceptible to manipulation because businesses can use non-cash expenses such as charitable write-offs, depreciation, and amortization to offset large capital expenses. Your business may see a profit each and every month, but if it’s tied up in accounts receivable or hard assets, you won’t have the cash flow to settle your cash outflow. Essentially, profit doesn’t keep the business running, cash flow does!
The Drawbacks to Maximizing Profits at all Costs
- Quantity over quality. When profit is the only priority, other factors start to suffer. One common example is using lower-quality materials in products or overworking staff to decrease spending and increase production. This kind of practice erodes trust, customer satisfaction, and reliability in your brand, causing high staff turnover and lowered productivity.
- Reducing expertise: If a profit-driven company will not invest in its staff, the lack of training available and the inability to upskill results in unhappy, dissatisfied staff which can lead to high turnover, lower quality production, and low company morale. Well-trained and highly skilled employees are vital for long-term sustainability and lowering turnover costs.
- It's short-term-based: Focusing solely on profit only benefits the short-term goals of a business. If you're in it for the long-term, profit should not be your only focus as it takes several factors successfully working together to achieve long-term success.
What is the Importance of Cash Flow Over Profit?
How Does Cash Flow Help Business Growth?
Can Cash Flow Help Pay Off Debts Faster?
How Does Cash Flow Help Attract New Investors?
How Can a Business Get Started Improving Cash Flow?
- Use automated software to track your incoming and outgoing cash
- Offer repayment options to your customers to get paid faster/on time
- Send invoices out promptly
- Offer an incentive to customers for paying early
- Discourage late payments by adding in a late payment penalty
- Review and reduce operating costs
- Increase your prices
Strategies for Improving Your Company's Cash Flow
One of the quickest and easiest strategies to implement is to review and improve your accounts receivable. Automate your invoicing system so that it sends invoices on time and automatically sends reminders.
Incentives for customers to pay early and on time are also great strategies. For example, offer an early-payment discount or bonus. Giving customers the option to spread the payments over a certain time period also helps avoid late or missed invoices.
Look at streamlining your operations to reduce costs. This doesn’t mean making your staff work more hours but rather looking at which processes can be automated to free up staff time to be productive elsewhere. Focus on spotting inefficiencies or unnecessary processes. Cutting red tape can save time and money.
Finally, review your employees’ roles to ensure they are performing the right tasks for their expertise. Verify that workloads are distributed evenly.
Common Mistakes Made with Cash Flow Management
- Only looking at profit and disregarding cash flow as a performance metric
- Not keeping on top of or monitoring your simple cash flow statement
- Not targeting unpaid or late invoices
- Failing to prepare for quiet periods of business
- Failing to prepare for taxes properly
- Trying to scale too soon or too quickly
Who is Responsible for Cash Flow Management?
When and How to Hire a Professional Financial Advisor?
If you don’t know what your cash flow situation is, then it’s probably time you got a professional to deal with your cash flow sheet. Similarly, if you struggle to determine what your cash flow is or lack the necessary financial knowledge to understand and analyze your statements, then you need to get the right expertise on board. Even if you feel like you have a good handle on your finances, a qualified individual will be able to spot areas for improvement and help you implement strategies to free up even more cash.
Once you’ve decided it’s time to take control of your cash flow, it’s time to hire an expert. EvolveCFO is the perfect option for small businesses. We provide financial assistance in all areas of accounting, including cash flow.
Our team works remotely and shares the necessary data through secure, cloud-based software so you can access it anywhere when you need it. Best of all, you only pay for the services you require with different monthly payment tiers to suit businesses at all stages of growth. There’s no contract either! Pay for our services on a month-to-month basis and cancel anytime.
EvolveCFO gives you the flexibility to have the financial assistance you need to get your cash flow in check at an affordable price point. If you like the sound of that, get in touch with us today.