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? In fact, there are some instances where cash flow and profitability may be exactly the same thing but this is would be for an extremely simple 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.
Think about buying a physical asset that will have long term value in your business such as a truck. Assuming you pay cash for the truck for let’s say $100,000, you experience negative cash flow of the same $100,000. However, your business still owns the truck and the second you buy the truck it is still worth the same $100,000. Hence at the time of the transaction, buying the truck will have no impact on your profitability: you have spent the $100,000 in cash but you have gained the asset of a truck worth the same $100,000.
Over time however, the truck will lose value. Accountants approximate the loss of value by using a number which they call “depreciation.” For example, if you were to assume the truck had a useful life of 5 years, you might assume that the truck evenly (or “straight line”) “depreciated” by 1/5 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 key 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) that you will on average still have to wait 3 months to receive payment for it. When you pay for the merchandise you experience negative cash flow but 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, on average 3 months later, you experience positive cash flow for the total amount of cash received, and your profitability is also increased, but only by the difference from the sale price, less the cost of the merchandise.
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 very big deal and you need to stay on top of it!
Bob Adams, serial entrepreneur and founder of BusinessTown.com.