When you are running a business it’s easy to confuse cashflow with profit. After all both could be considered to indicate that you’re making money, so what exactly is the difference between the two?
Profit looks at the total financial gain (or loss) that a business experiences over a given period – not simply at any one moment in time. It measures how much money is left after all expenses are deducted from a business’s revenue.
A business needs to be profitable in order to survive and thrive, but it is important that we do not look at profit as the only measure of business success.
A business could be very profitable on paper because of an innovative product, which sells well at a healthy mark-up, however, if the cash management in the business is poor, a profitable business can still fail if it runs out of cash.
Cash is the lifeblood of any business and is needed to:
- Buy raw materials or stock
- Pay wages
- Invest in the future of the business
- Buy plant & equipment
- Service debt within the business
- Reward the owners of the business
If the business does not generate sufficient cash from its operations to meet these obligations then problems can occur even the business is profitable.
Managing cash effectively involves:
Credit Control – assessing the credit worthiness of customers before extending credit to them and then ensuring that money owed to the business is collected in a timely and effective manner
Stock Control – ensuring that the amount of money tied up in stock is controlled and that stock levels are sufficient to meet manufacturing or sales demand but not excessive.
Purchasing Policy – negotiating good terms with suppliers to take best advantage of credit that they are able to extend.
Managing Borrowings – making sure that the level of borrowings taken on by the business is sustainable and that interest and repayments are serviceable without impacting on operational activities.
Just as we should not rely on Profit alone as a measure of success, the cash balance in a business can sometimes be misleading.
In recent times for instance, the favourable terms offered under CBILS and bounce-back loans have encouraged businesses to take advantage of these facilities even if the cash requirement was not necessarily there at the time that the loan was taken out. This was entirely rational business behaviour as the short to medium term future was so uncertain.
However, these sudden windfalls of cash into business bank accounts may have flattered the results somewhat and some business owners who possibly place more attention on their bank balance rather than other financial measures may have been tempted to reward themselves, extracting cash for personal projects without recognising that such loans will need to be repaid at some point.
Profit vs Cashflow
So, in business we actually need to be both profitable and have healthy cashflows – the two measures are not in conflict and should in fact be complimentary and there are tools that we go through with our clients to improve both.
Building on the profitability and cash generation elements of your business will ensure future success, reduce stress and provide financial freedom ultimately for both the business and its owner(s).
Please also read our blog post on top tips for cashflow planning for some more ideas.