Cash Flow and Profits: A Comparison
By Debbie Gregory.
Cash-flow and profit margin both relate to the health of a company. However, each term relates differently to the company’s bottom-line. Cash-flow is important to a company’s expansion and potential. Profit margin is a different concept that may relate more directly to the company’s bottom line.
Cash-flow governs the everyday workings of the company. Cash flow may come from any of a variety of sources, including the owner’s personal funds, investors, or loans, as well as revenue. Cash flow pays the bills, the employees, and the creditors in the short-term. Profits matter in the long-term, especially in the wake of large investments from investors or creditors.
For a smaller company with an independent cash flow, operations may continue for quite some time (or even indefinitely) before turning a profit, based on the enthusiasm and motivations of its operators. This is especially true with a home business. For a larger enterprises, profits must ultimately keep up with the cash flow. This is especially true when the original investors become creditors demanding payment.
So how do we more specifically define profits versus cash flow? “Profit” is basically the same as “net income.” Within a given period, your “profit” is your business revenue minus your expenses (including cost of providing products and services and overhead).
But how to manage cash flow? Assume a loan of $15,000, with a payment plan of $500 per month. That initial loan provides a healthy cash flow early in the history of the company, but the subsequent $500 per month will eat just that much into the profit margin.
Financial experts sometimes consider cash flow a better indicator of a company’s performance than profit margin. Cash flow affords better opportunities for growth. Cash flow may indicate better credit on the part of the company, and greater enthusiasm on the part of investors. By extension, the incoming monies may signal a brighter future for the company.
On the other hand, profit holds a different importance to the company’s bottom line and plans for expansion. A small side-business can emphasize profitability from the get-go, absent lofty ambitions. Smaller enterprises need not incur debt. Entrepreneurs with bigger plans must consider cash flow while they can maintain their company in the growth stage before reaching the critical mass necessary to generate independent profits.
A small business should consider maintaining a “cash flow statement” that details their periodic cash flow. These statements are called “free cash flow,” or “FCF” statements. In order to calculate your “FCF,” you should:
(1) calculate your operating cash flow
(2) subtract your capital expenditures
(3) on the chance that your company pays dividends, subtract your dividends, which are shares of profits paid to part-owners of the company.
Business owners should carefully monitor both cash flow and profits, for the sake of the progress of their company, as well as tax considerations. Cash flow could originate from an excited or generous relative, or a small business loan, or any of a variety of sources. Profitability depends on total revenue minus expenses, including negotiated payments to investors or lenders.
Profitability may indicate long-term success, but cash flow generally indicates engagement with the economy and a vibrant outlook for success. Healthy cash flow demonstrates that the company functions in the here and now. In many cases profitability may come afterward.
We hope that you have enjoyed this article and the prior one on profitability. We work hard to bring our audience timely and important information.
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