Accounting & Finance
What’s the Big Fuss about Cash Flow?
Before you go into business you dream about sky high profits! But once you get started in business you dream about positive cash flow! So, what’s the difference between cash flow and profitability? Aren’t they pretty much the same?
Before you go into business, you dream about sky-high profits! But once you get started in place, you dream about positive cash flow!
So, what’s the difference between cash flow and profitability? Aren’t they pretty much the same? In fact, there are some instances where cash flow and profitability may be precisely the same thing, but this would be for a specific business, such as your first lemonade stand.
The differences between cash flow and profitability are basically two-fold. First, you have some profitability items that are paper transactions only and don’t directly involve the flow of cash. The most common example is depreciation.
Therefore let’s think about buying a physical asset that will have long term value in your business, for example, a truck. Assuming you pay cash for the vehicle and that’s $100,000. You will experience negative cash flow of $100,000 on paper. However, your business still owns the truck, and it is worth $100,000.
Over time, however, the truck will lose value, i.e. it will depreciate, and there is an equation accountants use to calculate what the asset is worth every year it’s owned. For example, if you were to assume the truck had a useful life of 5 years, you might consider that the truck evenly (or “straight line”) “depreciated” by one-fifth of its value each year or in this case by $20,000.
Amortization is somewhat similar to depreciation but it pertains to non-tangible items. For example, the value of a patent may be considered to “amortize” instead of “depreciate” as it loses value over time.
Another critical difference between profitability and cash flow is the timing of transactions. Let’s say, for example, that you operate a retail store and that you turn your inventory three times per year. That means that your average item sits on the shelf for four months before being purchased. Let’s assume that you sell only for cash but that you are allowed 30 days to pay your vendors for your inventory. So, the net result is that you receive payment for your merchandise 3 months (4 months less 30 days) after you pay for the merchandise.
In other words, when you first pay for your merchandise (30 days after you receive it) by the time you’ve sold and received payment three months have passed. When you pay for the merchandise, you experience negative cash flow. However, your profitability is not impacted since you still own the merchandise, accounted for at the cost of your purchase. Then when you sell the merchandise, you experience positive cash flow and your profitability also increases. Profit is what you have after the cost of the merchandise is subtracted from the sale’s revenue.
Generally, in service businesses, cash flow is not as complicated or as much of an issue as it is in product businesses. However, there are exceptions. For example, let’s say you sell long term service contracts but only get paid at the end of the contract or at wide intervals. In this case, your cash flow will swing significantly as payments are received, regardless of how you book the profits from the contract.
Bottom line: cash flow is a huge deal, and you need to stay on top of it!