What’s the Difference Between Cash Flow and Profit?

In previous blogs, we’ve covered the Income Statement and Cash Flow Statement. It’s important for investors, especially those new to financial statements, to understand the differences between Cash Flow and Profit. While they are often used interchangeably, Cash Flow and profit are not the same.

In a truly great company profits and cash flow become like blood and water to a healthy body.

James Collins

The changes on the Income Statement affect the Cash Flow Statement, and the changes on the cash flow statement impact what can reoccur on the income statement. In essence, they are interconnected but represent different aspects. Profit shows how much money is left over from revenue after all expenses have been paid, while Cash Flow measures how much cash has come into the business and how much has left the business to generate that profit.

Both metrics are critical and paint different pictures. A company can be highly profitable yet have negative cash flow, creating financial pressure for the business. Conversely, a company can have negative earnings but positive free cash flow, especially as it increases top-line growth.

Understanding these differences is crucial for evaluating a business, particularly depending on where it is in the business growth cycle. The focus on profit directly affects cash flow. To create or increase profits, a business needs to concentrate on increasing top-line growth and effectively managing and improving operating efficiencies to control expenses. In order to grow, a business needs cash to fund investments and working capital which all contribute to top-line growth.

What is Profit?

Bottom-line Profit refers to the money remaining from revenue after subtracting all business expenses. Gross profit measures the profitability directly related to core business activity. For example, the cost of goods sold to produce that revenue. Net profit measures the final profit after subtracting all other business costs, including taxes, interest, rent, staff, and all other operating expenses.

Businesses aim to have both an increasing profit margin and a positive profit. Increasing profit often means increasing expenses to drive revenue. Pursuing profit and revenue can strain cash flow. To grow a company, you need cash to support these activities. A positive profit reflects that a business has some revenue left over, while a loss means that business expenses exceed the revenue.

As businesses mature and stabilise, profit is essential. A business cannot sustain losses indefinitely. However, a business going through a growth cycle or startup phase will often incur losses to facilitate future profitability.

In this case, accelerating revenue is the primary focus. The second focus is expenses and operating efficiency. This is why when I see a business with a net profit loss, it must have a high gross profit margin. A high gross profit margin means the cost to produce the revenue is healthy. What happens after this are the expenses in areas that help the company scale, such as staff, marketing, R&D, and rent. This is what creates a significant difference between gross profit and net profit.

Over time, as a business stabilises, managing the operating expenses becomes crucial. If managed well, every additional increase in top-line growth can start flowing directly through to the bottom-line net profit. When a company with healthy gross margins fails to efficiently manage the expenses of the business it often never sees a profit and will always require cash to survive.

What is Cash Flow?

Cash flow refers to all the cash that flows in and out of a business. Cash flow excludes money that customers owe you, bills you owe, as well as any cash in the bank. Operating Cash Flow is an honest look at how much of the income statement converted to cash.

A positive cash flow means more money came in from business activity and negative means more cash went out. Showing a profit doesn’t indicate that the business has that bottom line sitting in the bank. It’s a paper profit. You can record revenue, but no money has flowed through your business until the sale is paid for in cash. If you purchase inventory on credit, it is a paper expense until paid for in cash.

This is the key differences between cash flow and profit. If a company is scaling and looking to grow revenue, it takes CASH (money) to make money. If a business accelerates revenue without sufficient cash, it may not be able to pay for operating activities to support that growth.

Cash flow is essential for businesses of all sizes. If a business runs out of cash, it needs to raise cash by either issuing more shares or by taking on debt. On the reverse, a business can have positive cash flow but still not make a profit. This could be for a number of reasons, one of them being the working capital cycle allows the company to get paid in advance of when it pays out money.

A lot of high-growth companies are profitable with huge negative cash flow. This often reflects massive reinvestments to support scaling and increasing revenue. What happens is OCF may be healthy and positive; however, Capex and in particular growth capex may have huge outflows, which creates negative cash flow.

Out of Cash Flow and Profit what’s better?

Well, it depends. I want a business to manage cash flow efficiently and generate FCF. I also want that business to be highly profitable and cannot pick one over the other. However, as a guide, I believe if a business is in growth mode, scaling with the right business model, profit is key. This is why, understanding the business growth cycle will help to determine where to focus without saying, “It is negative, it’s a bad investment”.

A business that is really growing will require significant cash outflows to fund growth. The goal is to grow to a point where it can scale back capex costs, and that frees up a lot of owner earnings. This is where I believe cash flow becomes more important than profit. When a company passes the massive investment and growth phase and is profitable then the focus shifts to FCF.

One thing that won’t change is if a business fails to ever become profitable, then that will directly impact cash flow. Profitability over the long-term will be the driver of cash flow. So you cannot achieve one without the other. I believe becoming profitable should be the priority initially, while long-term positive cash flow should be the goal of all businesses.

A company that takes a loss will continually eat into cash. This creates a cash deficit for a while as it’s using cash it raised from investments to support working capital. When this runs out, it’s the lack of cash flow that will kill the business.

At the same time, a focus on increasing profitability is not always ideal if it means it will cause a cash flow problem. Sometimes a company focuses on increasing profits, but with the rise in revenue comes the rise in expenses and outflow of cash.

In Summary…

It’s important to remember that profits are only beneficial if they are eventually converted into cash. Both cash flow and profit are indicators of a business’s financial health and operating efficiency. While profit is the goal, cash flow determines whether a company can sustain that goal in the long term. Cash flow is essentially the lifeblood of a business.

The focus should be on increasing profits while also improving margins to enhance efficiency, and then converting a significant portion of those profits into cash. The business model will dictate where management’s focus should lie in the short and long term.

To make money by increasing net profit, while simultaneously increasing return on investment, and simultaneously increasing cash flow.

Eliyahu M. Goldratt

In my experience of building companies, I used a five-step process. The focus shifted in stages, 1) increasing revenues 2) reducing operating expenses 3) boosting profits 4) enhancing operating cash flow, and then 5) transitioning into generating free cash flow. It’s a gradual process, and while profits increased, I never lost sight of cash flow.

Effective management of working capital, accounts receivables, payables, and prudent inventory management significantly impacts the amount of operating cash flow generated from the profits.

Negative cash flow isn’t necessarily bad, but poor cash flow is. A business can be incredibly efficient and still have negative cash flow. However, poor cash flow can stem from issues related to collecting payments, paying staff, inventory management, and other operational inefficiencies.

In summary, while this brief overview of the differences between cash flow and profit may not provide a definitive answer, it’s important to understand that both are crucial. Investors need to comprehend how one impacts the other and determine when to prioritise profit and when to prioritise cash flow from an analysis and investment decision perspective.