The money flowing into your business and the profit you generate might seem like they should align perfectly, but in reality, they often tell very different stories.
Cash flow reflects the movement of money in and out of your business, capturing the day-to-day liquidity that keeps operations running. Profit, on the other hand, represents what’s left after all expenses are deducted from revenue, like a snapshot of your business’s financial success. It’s also what the IRS use to work out the tax you owe from your end-of-year accounts, which is calculated by adding revenue and subtracting all expenses, leaving a profit balance.
The critical difference is the way certain financial data is treated inside the profit and loss account, as it records only what happens in the financial year. Some things either don’t get counted or are diluted as a result.
For example, you have sales of $500,000 with running costs of $360,000 during the year, and you buy a $140,000 piece of machinery. As far as you are concerned you’ve made zero profit ($500,000 sales less $360,000 expenses less $140,000 machinery).
But that’s CASH FLOW, not PROFIT.
The problem is that in a profit and loss, you only add in the depreciated value of the asset as an expense, rather than claim the whole amount. For example, if depreciation is 10%, you’d only claim $14,000 for the year, not $140,000
The profit you’d report for taxation in this example would be $126,000 even though you have zero in the bank.
Let’s explore some of the other common causes of differences between cash flow and net profit.
You can only count inventory or raw materials that is used during the year as an expense. For example, if you start with $100,000 of inventory on day one of the financial year, buy $200,000 worth over the year, and at the end of the period you have $180,000 left. You can’t claim all the $200,000 of inventory as an expense. The calculation is $100,000 + $200,000 less the $180,000 remaining, which equals $120,000.
Watch out for buying large amounts of inventory, even if suppliers have sales and offer good deals, at the end of the year. It will reduce your cash reserve but not move the dial on profit.
If you bill out a job for $50,000 which remains unpaid at the end of your financial year, the $50,000 gets added to sales, and so counts towards your profit number, but the cash hasn’t hit your account.
If you pay in full for anything like accounting services or insurance that crosses over your financial year, you’ll only claim the portion used up. For example, if you pay insurance of $10,000 to cover 12 months, but your financial year ends six months after you’ve paid, you’ll only be able to claim $5,000 in the current year as an expense, while the whole $10,000 has exited your account.
The reverse works as well. If you’ve pre-paid, then the following year you can claim the remainder as an expense, but the cash flow stays untouched. You win.
There are many reasons why cash doesn’t equate to profit:
These scenarios highlight the importance of actively managing your cash flow alongside your profit to make sure your business remains financially stable and prepared for unexpected challenges.
To better balance the difference between cash flow and profit you can:
Remember to plan for the dates when your business’s taxes are due. A large tax bill is difficult to pay if you haven’t planned for it, especially if it arrives at a time when your cash reserves are low.
The better you understand the difference between cash flow and profit, the better placed you’ll be for making informed financial decisions and maintaining the health and stability of your business.