As a business owner, you are responsible for knowing the financial position of your business. You can do this but looking at financial reports and communicating with your accountant.
Ideally, a business owner should look at their financial statements monthly but if it’s been a while you may notice a discrepancy.
Why does the income statement show you are making a good profit, but your bank account is not showing that amount in cash?
While income and expenses impact your profit, cash flow tracks the day-to-day cash movements in your business.
While they may seem similar, it’s crucial for Australian business owners to grasp the distinctions between the two to make informed decisions about the financial health and growth of their companies.
The Difference Between Cash Flow and Profit
It’s easy to get mixed up between cash flow and profit because many things that bring in money (like sales) are both income and cash coming in. For example, when you sell a product and get paid right away, that’s both income and cash flow. It’s the same with expenses: buying stuff for your business, like ingredients, is an expense and also cash going out.
But not everything is so straightforward. Some cash movements aren’t counted as income or expenses. For instance, if you buy a big piece of equipment, you’re spending cash. But this isn’t an expense straight away. Instead, it’s spread over several years as depreciation, which shows how much the equipment wears out and loses value each year.
Also, when you take a loan to buy something big, the interest you pay is an expense. This is because it’s the cost of borrowing money. However, the regular payments you make on the loan aren’t considered an expense. They’re just you paying back the borrowed money, but they still affect your cash flow because it’s cash leaving your account.
So, let’s break it down. Cash flow is about the cash coming in and going out of your business, while profit is more about income and expenses over time. They’re related but not the same thing.
Cash Flow: The Lifeblood of Your Business
The adage “Cash is King” holds true when it comes to managing your company finances. Cash flow represents the movement of money in and out of your business, akin to transactions in your business “chequebook.”
Unlike profits, cash flow is a short-term measure, answering the question: Can I pay my bills?
You can receive cash from a multitude of revenues and categorise it into three types:
- Operating Cash Flow: Reflects the net cash generated from regular business operations.
- Investing Cash Flow: Represents the net cash generated from investment-related activities, such as purchasing equipment or property.
- Financing Cash Flow: Describes how cash moves between the company and its investors, owners, or creditors, including debt, equity, and dividend payments.
Breaking your cash flow into these categories helps to define whether the business has earned the cash (operating) or received it temporarily and will eventually need to pay it back (financing).
Why Cash Flow Matters
Cash flow is key in business because it’s the cash you need to pay immediate expenses like wages and supplier bills. In Australia, there’s often a delay between making a sale and actually receiving the cash, especially with credit sales. This means you need enough cash on hand to cover operations while waiting for payment.
Consider a tradie who gets only half the payment upfront for a job. They need cash to pay for supplies and labour until the rest of the payment arrives. Without sufficient cash, they can’t complete the job, even if they’re due to make a significant profit.
For business growth, positive cash flow is essential. Expanding requires funding for more staff, equipment, and inventory. Money spent on extra stock is tied up until those items are sold.
Even if you’re fully booked, it doesn’t guarantee immediate cash availability. If you need more cash to grow, lenders will assess your cash flow to determine if you can afford the extra debt.
Profit: A Measure of Financial Performance
Profit, on the other hand, is what remains after deducting all operating expenses from revenue.
It’s the bottom line on your income statement, indicating how well your business performed in terms of generating income.
Profit figures include non-cash line items such as depreciation expenses and goodwill write-offs (donations).
It reflects the financial health of your business over a medium-term period, answering the question: Am I making money?
Suppose your business, “Aussie Widgets Pty Ltd,” generates $100,000 in revenue. After accounting for the cost of producing widgets, operational expenses, and taxes, you’re left with a profit of $20,000. This indicates that, on paper, your business is $20,000 better off than when you started.
There are different types of profit as well:
- Gross Profit: Revenue minus the cost of goods sold, excluding fixed costs.
- Operating Profit: Net profit from regular business operations, excluding certain cash flows.
- Net Profit: The final income after deducting all expenses, including taxes and interest payments.
The different types of profit can show the markup of the goods sold (gross), how much money your business is making (operating), how much shares are worth and how much dividends you can receive (net).
Why Profit Matters
Besides the obvious need of every business to be making money (right?), you would need profit to reinvest into the business. You can allocate funds to grow your startup, hire talent, or upgrade products.
If you have had to get financing at any point in your business journey, you would need to produce a profit to pay off long-term debt. Improving your credit score will help to reduce monthly bills and create financing opportunities.
As a business owner, you could use the profit to pay dividends to yourself if you do not give yourself a salary.
Making Informed Decisions
While profit and cash flow are intertwined, they offer distinct perspectives on your business’s financial health.
It is possible for a company to report profits but go out of business because they can not pay their bills.
While alternatively, a negative cash flow could indicate growth. Especially if you just paid for a second-location property. However, if it is accompanied by losses on the profit statement, it may signal an unsustainable business model.
By understanding the nuances between them, Australian business owners can navigate financial decisions more effectively, ensuring sustained growth and success.
Remember, profit is the destination, but cash flow is the journey. By understanding and managing both effectively, we can ensure your business not only thrives on paper but also in the bank.
If you have any questions or need further assistance, please contact us at office@liftaccounting.au or call us at (02) 4344 2460.
