Various metrics can be used to measure a company's financial health, but arguably the two most important are 'profit' and 'cash flow'. But what do the two terms mean, and how do they differ? This blog post endeavors to find out.
What is profit?
In the simplest terms, 'profit' describes the money left over once a business has paid off all its expenses. A business can be said to be 'in profit' when the revenue generated from the sale of goods or services exceeds the total cost of producing them.
Profit can be expressed and measured in different ways, including:
Gross profit: the difference between sales and the cost of goods sold (COGS). COGS reflects all the direct costs associated with producing or purchasing the goods a company sells.
"For example, if Company A has $100,000 in sales and a COGS of $60,000, it means the gross profit is $40,000, or $100,000 minus $60,000."
- Investopedia
Operating profit (operating income): The operating profit is derived after subtracting operating expenses (such as salaries, rent, and utilities) from the gross profit. You're left with a smaller, and truer, indication of your company's profits.
Net profit (Net Income): The net profit is your company's 'bottom line'. It's the final amount you come to after deducting all expenses ― including taxes and interest ― from the operating profit.
What is cash flow?
Cash flow, as the name suggests, refers to the 'flow' of money in and out of your business. A business with a positive cash flow means more money is coming in than is going out, while a negative cash flow indicates the opposite.
There are three main components of cash flow:
Operating cash flow (OCF): This represents the cash generated and used by a company's core business operations. It includes cash received from customers, as well as cash paid for operating expenses such as salaries, utilities, and inventory.
Investing cash flow (ICF): This reflects transactions associated with the purchase and sale of long-term assets ― such as property, equipment, and investments. Investing cash flow can be expected to be negative when a company is making significant capital expenditures ― for example, when it's growing.
Financing cash flow (FCF): Also referred to as 'cash flow from financing activities', this refers to the funding a company generates over a given period ― including activities such as issuing or repurchasing stock, paying dividends, and borrowing or repaying loans. Financing cash flow is positive when a company raises capital (e.g., through issuing stocks or borrowing), and negative when it returns capital to investors.
How are profit and cash flow related?
Profit and cash flow are related but distinct. Cash flow measures the movement of cash in and out of your business, while profit measures the money left over once expenses have been subtracted from revenue. As such, they represent different aspects of a company's financial performance.
Here are the key differences between profit and cash flow at a glance:
Timing
Profit: Profit accounts for revenues and expenses, regardless of when the cash is actually generated or spent. It also includes non-cash items such as depreciation.
Cash flow: Cash flow reflects the actual movement of cash in and out of a business, and considers the timing of cash receipts and payments.
Sustainability & Growth
Profit: Profitability is crucial for the long-term sustainability of a business, and is often linked with its growth potential.
Cash flow: Positive cash flow is essential for meeting short-term obligations, investing in growth opportunities, and ensuring the business' day-to-day operational needs are met.
Accrual Accounting vs Cash Accounting
Profit: Profit is often calculated using accrual accounting, which recognizes revenue and expenses when they're earned or incurred ― not necessarily when cash changes hands.
Cash flow: By contrast, cash flow is calculated using cash accounting principles ― considering actual cash receipts and payments.
Investing and Financing Activities
Profit: Profit does not explicitly account for cash spent on investments in long-term assets, or financing activities such as loan repayments or stock buybacks.
Cash flow: Cash flow accounts for investing and financing activities ― providing a comprehensive view of how cash is used for capital expenditures or raised through financing.
What about revenue?
Revenue is an entirely separate financial metric. It refers to the total income generated by the sale of goods and services, without the deductions associated with profit calculations. It's simply a measure of how much money a company is bringing in.
What's more important?
Profit and cash flow are both 'important' financial metrics, and the information they reveal is of value to businesses in different ways. Profitability might be of primary interest to a company's shareholders, while a healthy cash flow will please the accountants. Neither should strictly be considered more 'important' than the other.
"Both profit and cash flow are important in their own ways. As an investor, business owner, employee, or entrepreneur, you need to understand both metrics and how they interact with each other if you want to evaluate the financial health of a business."
- Harvard Business School
Keep an eye on the Quadient AP blog for more accounting best practices, and explainers on key financial terms and processes.
