Many entrepreneurs confuse the terms cash flow and profit. A simple definition of cash flow is the movement of money into and out of a business. Profit on the other hand is how much money is left after subtracting all expenses from the income generated from sales. These two terms are not interchangeable. Your business can look profitable, but not have cash in the business. This could be due to several situations.
- You bought a large piece of equipment on credit in the past and are currently paying on the loan. Payments to reduce a liability do not reduce profit. However, the cash was spent reducing the money available to the business.
- You drew money out of the business as payments to yourself. These are not expenses of the business but rather a reduction of equity. Therefore, profit remains the same, but cash is reduced.
- You file your tax returns on an accrual basis (income is counted when the client is invoiced whether payment has been received or not) but the clients haven’t yet paid.
On a similar note, your business can be operating at a loss, but you could have money in the bank. This could be because:
- You invested money into the business (increase in equity), but the sales aren’t high enough to offset incurred expenses resulting in a loss
- You received a loan for operating capital (liability) but expenses are still higher than income from sales
- You sold equipment (increasing cash on hand) but it wasn’t inventory sold to a customer to increase income
It’s important to watch both profit and cash flow to truly understand what is happening in your business. Review your reports often to see where adjustments need to be made to reduce expenses, increase income, and keep enough money in the bank to cover expected outflows.
Need help with your bookkeeping? We can help. Contact us today at [email protected] or 310-534-5577. We’ll be glad to assist you!
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