Explaining the Differences in Cash Flow and Profit
While cash flow and profit are both highly desirable objectives for most businesses, they aren’t the same thing at all, and in fact there’s a considerable difference between the two. For instance, your business could have made significant profit in a given year, but you find yourself with no available cash at year’s and to meet ongoing expenses of the business. So what exactly are the differences between cash flow and profit?
Cash flow refers to money flowing into and out from your company, whereas profit is simply a calculation of the difference between your company’s total income and total expenses. It is very possible for a company to have positive cash flow with no profit, if incoming cash comes from a loan for example, rather than from actual business sales.
On the other hand, it’s also possible to have little or no cash flow, but at the same time to be very profitable. One way this can happen is if the owners are withdrawing cash from the business to pay for personal expenses. The real difference between cash flow and profit basically boils down to the sourcing for your company’s cash transactions, as well as the accounting basis being used.
What is meant by accounting basis?
There are two basic types of accounting basis, both of them referring to the time frame when expenses and income are reported, and it’s easy to see why this can have a great impact on profit and loss statements. The accrual basis method is used when you want to recognize expenses and income right at the time they occur naturally for your business. The cash basis method involves recognition of both expenses and income only when cash is actually exchanged.
Why it matters
If you aren’t recording income and expenses until cash is actually exchanged, your financial statements will be missing all your credit transactions for a given reporting period, with obvious consequences for your profit statement. Cash flow on the other hand, is relatively free of accounting methods, and can be determined simply by consulting your company bank account balance. While profit and loss can be subject to your accounting basis, cash flow is either there in your bank account, or it isn’t.