Cash flow versus profit

In short

A friend of mine ran a small print shop for eleven years, and he once told me he felt rich on paper and broke in the checking account. If you own a business, you have probably felt that same split. Profit is what your books say you earned. Cash flow is what actually moved in and out of your bank account. A business can show a profit and still miss payroll, so both numbers matter. Many owners check their cash position every week, not just at tax time. Faster customer payments and longer supplier terms both ease the squeeze. A cash cushion sized to how long bills take to come due gives a business room to breathe. Owners who track both numbers tend to feel steadier.

The whole of it

What it is

I once watched a baker explain to her son why she was tired even though the shop had a good month. She had sold plenty of cakes, and the ledger looked fine. Yet the flour bill was due before the wedding party paid her. That gap is the whole story of this subject.

Profit is revenue minus expenses over a period of time. Revenue is the money a sale earns, counted when the sale is made. Cash flow is the real money moving in and out of your accounts, counted when it moves. Those two clocks run at different speeds. A sale on credit adds to profit today and adds to cash weeks later. A big equipment purchase hits your cash at once, but accounting spreads its cost over many years.

You are not doing anything wrong when the two numbers disagree. They measure different things, and both matter. Profit tells you whether the business model works. Cash flow tells you whether the doors stay open this month.

How it works

If you are holding a stack of unpaid invoices, you already know how this works. Many small businesses use accrual accounting, which records income when it is earned and costs when they are incurred. Others use cash accounting, which records income when it is received and costs when they are paid. The IRS explains both methods in Publication 538, called Accounting Periods and Methods, and your choice shapes how profit looks on paper.

Cash flow comes in three streams. Operating cash flow is the money from running the business day to day. Investing cash flow is money spent on or earned from long term assets like a truck or a building. Financing cash flow is money moving between the business and its lenders or owners, such as loan payments or an owner draw. A statement of cash flows lays these three out side by side. The statement of cash flows is one of the standard financial statements, and the Small Business Administration publishes free guidance on managing cash at sba.gov.

Several things pull profit and cash apart. Unpaid customer invoices count as profit but not as cash. Inventory you buy sits on the shelf as cash gone out and no profit yet. Loan principal you repay is not an expense, yet it drains your bank balance. Depreciation, which spreads an asset's cost over its life, lowers profit but costs no cash that month. Taxes and owner pay also hit cash on their own schedule.

The numbers, and where to find yours

A neighbor of mine kept her numbers in a shoebox until a lender asked to see them. Your numbers are easier to find than you may think. Your profit lives on your income statement, sometimes called a profit and loss statement. Your cash flow lives on your statement of cash flows, and your bank balance tells the daily truth.

Three figures are worth knowing by heart. The first is net profit, which is revenue minus all expenses. The second is net cash flow, which is cash in minus cash out for the period. The third is your cash runway, which is your cash on hand divided by your average monthly cash spending. If you have $18,000 in the bank and spend $6,000 a month, your runway is $18,000 divided by $6,000, which is 3 months.

Accounting software pulls these reports in a few clicks. If you file taxes as a sole proprietor, Schedule C reports your profit to the IRS, and the instructions for it are on irs.gov. Your bank statements show cash. Compare them side by side each month, and the gap will teach you a lot.

A worked example

Let me tell you about a woman named Dolores Hayes, who runs a small landscaping company. In March she finishes a large job for a property manager. She bills $24,000 on March 25. The terms say payment is due in 45 days.

Her costs for the job are real and immediate. She pays $9,000 for plants and materials, $7,500 to her crew, and $1,500 for fuel and equipment time. That is $9,000 plus $7,500 plus $1,500, or $18,000 in costs.

On an accrual basis, her March profit on this job is $24,000 minus $18,000, which is $6,000. Her books look good. Dolores feels proud, and she should.

Now look at her bank account. She paid out $18,000 in March and received $0 from this client. Her cash flow on this job for March is $0 minus $18,000, or negative $18,000. Her other work brought in some money, but she started March with $15,000 and ended it with $4,000. Meanwhile her payroll for the next two weeks is $7,200.

See the trouble? She is $3,200 short, since $7,200 minus $4,000 is $3,200. She made a profit and still cannot cover the crew. The money arrives in mid May, and the crew must be paid in early April.

Dolores has choices. She can call the client and ask if payment can come sooner. She can offer a small early pay discount, say 2 percent, which on $24,000 costs $480. She can ask her plant supplier for 30 days instead of paying at once. Or she can use a short bank line of credit, which has interest costs she should add up first. Any of these is a fair move. The point is that she saw the gap before it hit her, because she watched cash and not only profit.

Where it goes wrong

I have seen smart owners trip on this, and it is no mark against them. The most common slip is growing too fast. More sales mean more materials and more labor paid up front, while customers pay later. Growth can eat cash even when every job earns money. It sounds backwards, and it is true.

Another slip is treating the bank balance as profit. A full checking account may just be money owed to a vendor, a tax bill, or a loan payment coming due. A third slip is ignoring taxes. Profit is taxed even when the cash has not arrived, so an owner can owe tax on money not yet in hand. The IRS explains estimated tax payments in Publication 505, called Tax Withholding and Estimated Tax.

Owners also forget that big purchases hit cash in one bite. Buying a $30,000 van with cash lowers the bank balance by $30,000 today, while profit shows only a small slice of that cost each year. And some owners pay themselves from the bank balance without checking what is owed. Slow, steady habits fix most of this. Send invoices the day work ends. Follow up on late ones. Set aside tax money each month. Keep a cushion.

Questions to answer before you leave this page

If you looked at your bank account right now, would it match the profit on your latest income statement, and if not, what explains the gap? How many days does a customer usually take to pay you, and how many days do you take to pay your own suppliers? What is your cash runway in months, and does that feel safe for the kind of year you run? Do you know which of your costs hit your cash all at once and which are spread out? Have you set aside money for taxes on profit that has not yet turned into cash? And if your biggest customer paid a month late, could you still make payroll?