Profit and Cash Flow Explained
What’s the difference between profit and cash flow?
Often, it’s the difference between success and bankruptcy.
Before we begin, let’s use clear language. I won’t say “income” because different people mean different things by that word. I’ll say “revenue” to mean money that comes in from selling a product or service.
Imagine two kids who want to start a lemonade stand. They plan to charge 50 cents per cup. If they sell 100 cups, they will make 100 times 50 cents, or $50 of revenue. Of course, they know it takes money to make money. They figure each cup costs 13 cents to make: 10 cents for ingredients, and 3 cents to pay protection money to the neighborhood bully. Their expenses will be 13 cents times 100 cups, or $13. They will have revenue of $50, expenses of $13, and their profit–revenue minus expenses–is $37.
Profit is the money left once expenses are paid. Some people think business owners can take profit to the bank. If only! Profit is used to pay for any new equipment or materials needed for the business to grow. And unless you buy a politician or two, you pay taxes out of profits as well. (Sometimes, profit is given as “pre-tax profit” and “after-tax profit,” so you know what the business produced on its own.) Only after paying for growth and taxes do owners get to take money home.
Our kids are ready to go! They needn’t buy equipment or pay taxes, so they’re eager to start their business and bank their $37.
But wait! If only this story were so simple. There’s a dastardly twist!
On the very first day, the kids go to the store to buy lemons … only to find out neither of them has any allowance money left. The store won’t loan them the lemons, so they can’t even get started. They’re out of business before they begin, thanks to cash flow.
Cash flow refers to _when_ a business needs money. Often, businesses spend money on salary, utility bills, and lemons before they bring in any revenue. By plotting out when cash will come in and when it needs to be paid out, a business can identify when it needs cash on hand, and can do what it takes to make the cash available.
Companies often take out loans to survive until revenue comes in. If our kids must pay the grocery store $5 for lemons today in order to make $50 by selling lemonade this weekend, they can ask Mom or Dad for a loan, to be paid back once the lemonade sales come pouring in. They borrow $5 today, make and sell their lemonade, and then pay back the loan next week.
What about the protection money for the bullies?, you ask. Well, the bullies are kind, generous people who understand cash flow. They’re willing to let our entrepreneurs pay after the revenues come in, avoiding a cash flow crunch.
Cash flow and profit don’t always match up.
A company can be profitable and still go bankrupt from cash flow problems. If they must pay for materials in January but don’t get paid by their customers until June, they need a loan to survive until June. If they don’t get that loan–even if they have _guaranteed_ sales in June–then they will go out of business. Sometimes customers themselves will pay in advance, effectively giving an interest-free loan to a company to help cover cash flow.
A company can have great cash flow, but not be profitable. Amazon.com raised so much money by selling stock in the mid-1990s, that they had $2,000,000,000 in the bank. Every year, they spent more money than they made, so their yearly profit was negative. But because they had so much money saved up, they could afford to make up the difference out of their bank account. The big stock market cash inflows made up for the continual losses. Only after a decade did Amazon actually start making a profit as a company, so they now have good cash flow _and_ are profitable.
So remember: profit is how much money you have left after you get your income and pay your expenses. Cash flow is when you actually get and pay the cash. In the long-term, you must eventually get profitable or find someone like stock investors to keep giving you cash to make up for your losses. In the short-term, even if you’re profitable, you survive or fail based on whether you have cash to pay the bills. That’s why they say Cash Flow is King.
Fabulous..Thank you for enriching my vocabulary. So clear!
I just gave a voice coaching session to beginning 6 graders and was mindful of simplicity and clarity. Turned out it was my best class for any age.
Thank you again for doing the same for me,
Sincerely,
October 1st, 2007 at 8:58 amBertrand
Thanks for the explanation. When trying to evaluate a business, how is one to determine good versus bad cash flow - and how does one know what the owner receives for payment. Thanks in advance.
January 27th, 2008 at 8:39 pmGood or Bad cash flow depends on how much you invested and what kind of return you can get with other investments.
You can look at cash flow as a return on your investment. If you invest $1000 to create a business that is giving you $100 of cash flow a year, you can think of that as 10% cash return on your investment.
It’s important, though, to add in to cash flow any expenses you know will have to be made but aren’t being made this year. If the above business requires an additional $50 investment every 5 years, say to refurbish a piece of machinery, then your return is on average the $100 cash minus $10 ($50/5 years) or $90 per year, or 9%. That may still be an investment worth doing, but don’t be surprised when you make less than 10%/year overall. The periodic-but-required expenditures lower the return, even if they don’t happen in the current year.
January 28th, 2008 at 11:17 am