Cash Flow Vs Profit
By Travis Bacon
November 14, 2021
So you're looking at your Xero file and notice you made a huge profit (income less expenses = profit). Congratulations, great work! But, then you take a look at your bank balance and there is buggar all cash in your bank. At TaxDigital, we would instantly take a look at your cash flow, or money deposited less funds withdrawn from your bank.
This is common, especially amongst small businesses just starting out and in the first few years of the growth phase. So, what is the difference between profit and cash flow and why should you care? Let's take a closer look.
In its most basic form, profit is is the result of your revenue minus your expenses. Sounds easy, and it is, but let's take a closer look. Let's say you buy some stock for $50,000 and sell that stock for $100,000. We would say that you made a profit of $50,000. And that's a fantastic profit margin! Profit can then be distributed to the owners of the business.
Cash flow is the amount and timing of receipts and payments you make from your bank account. This is where profit can take a turn for the worse. Let's continue with our example above, but add dates into the transaction.
You purchase your stock in January for $50,000 and then sell that stock in March for $100,000. The customer then doesn't pay for the stock until sometime in April as they are on 45-day payment terms. For the March quarter, we would still record a profit of $50,000, but there would be no cash in the bank. So your customer would owe you $100,000. Assuming that the customer pays on time, you would still somehow have to keep the business running and put food on your table for almost five months while you wait for that cash to hit your bank account.
Essentially your cash flow is negative, while your profit is positive. As you can imagine, this situation can quickly cripple a business.
At TaxDigital, we recognise that cash flow is an important metric. However, just like profit, it can't be used to evaluate your business without looking at other metrics. More than ever, small business owners need to assess their business regularly. (And no, once a year is not enough! Once a month is ideal.)
We recommend a 3-way forecasting model to ensure your profit, cash flow and other metrics are all monitored. To effectively track your finances, you need to ensure your bookkeeping and reporting responsibilities are as up to date as possible on an ongoing basis. Xero provides great analytics software to help review your past transactions and estimate your future transactions. Still, there is nothing like a well-seasoned accountant to cut through the smoke and mirrors.
Tips to Positive Cash Flow
Here are some final tips for positive cash flow in your business.
Get your bookkeeping up to date
Monitor your cash flow, and other metrics, monthly
Dial in your pricing models
Review your customer receivables and adjust payment terms
Minimize interest and late fees
Reduce your customer payment terms
Trying to plan forecast your cash flow and manage your business is a big ask. Don't worry, you are not alone and we get it! If you would like some personalised advice or assistance, feel free to reach out to us on 0407 438 849 or email@example.com.
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document, you should assess your own circumstances or seek personalised tax advice from us at TaxDigital. Information is current at the date of issue and may change.