Running a successful business is all about making a profit, or so we’re often told. In truth, that’s only part of the picture and the state of a business’ cash flow can often be a better indicator of the health of the business. A profit-making business can still run into serious trouble if it doesn’t manage its cash flow effectively so it’s vital to have a clear understanding of the difference between cash flow and profit.
In simple terms, profit is a narrow term that describes the amount left over from sales revenue once all business expenses have been deducted. Sales revenue itself is simply the amount that a customer pays for a business’ product or service. For example, if your business is able to provide a product or service for £50 in total costs and you can sell it for £100, your business has made a £50 profit.
In contrast, a business’ cash flow covers all the money that comes in and out of the company. This includes sales and other business operations, as well as financing and investment. It’s all very well making a profit on paper but what if your customer is late with payment and your business has bills that need paying? If your business calculates its financial accounts using the accrual method, you need to be able to work out not only your accrual profits but your cash flow profits too.
Accrual accounting is a method that shows how well your business is doing over an extended period of time by tallying your company’s income as well as expenses. Income is accrued as soon as you make a sale, regardless of whether you receive the cash immediately or not. Likewise, expenses are recognised as soon as they are incurred, rather than when the money is paid. This is different to cash accounting which recognises a sale in terms of income only when cash is received, and an expense only when cash is paid out.
While cash accounting will more accurately represent the cash flow of a business, most accountants recommend the accrual method for calculating business health. Although there will be a difference in terms of timing between business income and expenses versus cash inflows and outflows, you can work out your business cash flow profit by using a balance sheet for the period in question and making adjustments to your accrual profit.
Calculating Cash Flow Profit
To calculate the cash flow profit of a business, you should start by deducting depreciation expenses from your net profits. Depreciation expenses show the annual cost of the assets that are required for your business operations. After calculating depreciation costs, you’ll need to make further adjustments to reflect increases or
decreases in Accounts Receivable and Payable, as well as changes to your Inventories and Notes Payable.
Understanding the difference between revenue and profit, cash flow and net cash flow is key to running a healthy and successful business.
If your business is having cash flow problems, don’t hesitate to get in touch and speak to one of our experts about the best solution.