THE DIFFERENCE BETWEEN CASH FLOW AND PROFIT
Without controversy, the dream of every entrepreneur or CEO is to grow his or her business and make it profitable. However, not knowing the difference between cash flow and profit has rather caused many businesses to grow rapidly and then fail at the end.
Before you grow your business, you really have to understand the difference between cash flow and profit. Your cash flow statement is different from your profit & loss statement. Cash flow is the movement of cash in and out of the business as a result of operational, financial and investing activities. Profit, however, is the difference between your sales and expenses for a period.
Below are three ways a lack of knowledge by business owners on the difference between cash flow and profit can cause their rapidly growing business to fail?
First Way: Profitable Business but Bad Cash Flow
A business can be very profitable with growth possibilities but have a bad cash flow. A quote from income-outcome.com stated, “The vision starts the business, profitability helps the business grow, and cash flow is the day-to-day driver.”
You are running a production company where you’ve paid your suppliers and borne the cost of manufacturing the goods. You went ahead to supply the products to your customers and probably made about 30% or 40% of profit. However, you wait for the cheque and it comes 45 days later!
What does that mean, your business is profitable? Yes, you made a decent profit, but there was bad cash flow. And bad cash flow can kill your business. That simply means you’ll have to wait for your customers to make payments before going ahead with the next production!
|Image Source: the virtual bean counters|
Second Way: Expanding for Profitability but Being Cash Handicapped
Another avenue your growing business can fail if you lack knowledge on the difference between cash flow and profit is when you are expanding your business. This is really dangerous. Be careful when growing your business, if you don’t take care, business growth can lead to business failure!
Let’s take an example: Assuming Mr. Edward has a shoe production company. His company produces 1,000 shoes per month with net expenses of GH¢12,000.00 and net sales of GH¢ 20,000 per month. This means he makes a net profit of GH¢ 8,000.00 per month.
Well, his business is growing. Now he wants to expand his business and double his profit. This requires that, he doubles his inventory, enlarge the office space, hire more employees and increase other production costs. To implement this growth strategy, Mr. Edward must have the physical cash available to invest in the business expansion. From there he can make his target profit.
But this is often not the case, most businesses fail to develop a strategic plan and analyze their cash flow position before embarking on the expansion. Most entrepreneurs just invest in more inventories without properly planning other cash needs. So, before they realize, they are left with utterly no cash in hand to cover the day-to-day operational costs. If this is not handled well, the growth can lead to business bankruptcy.
Third Way: Making More Sales but More Cash Flowing Out
It is amazing how this happens. Many business managers and entrepreneurs fail to find the net cost and the net profit of each product. They don’t add up all the small costs to the product before coming out with the final price for the product.
So what happens? For example: A business makes sales of GH¢ 5,000.00 but realize that GH¢ 4,800.00 has gone out of the business leaving a gross profit of GH¢ 200.00 which may not be enough to cover other operational expenses that were ignored. They made a lot of money but more cash was going out!
All business owners must first of all know that there is a difference between cash flow and profit. You can be making profit but still have little cash available to run your business. To avoid this, develop a strategic plan at all times taking into account a realistic cash flow forecast, good working capital cycle management and decent profit margins for all your products.