What's the difference between cash flow and profitability in business? Learn how these business terms impact efficiency, business operation, and more.
Just because your business turned a profit doesn’t mean it's cash flow positive.
Some business owners use the two terms interchangeably, but they mean entirely different things—and can make or break an enterprise. A business can end the year in the black yet still have no money in the bank. That can be problematic. A shortage of cash is a major reason businesses fail. While profitability is the end goal, without cash flow, it’s hard to achieve.
What is Cash Flow?
Cash flow refers to the money that comes in and out of a business and is used to fund operations on a day-to-day basis. It’s used for inventory, payroll, and marketing. Having enough cash flow is all-important to a business when it’s starting out. A shortage of cash flow means the business can’t make payroll, pay suppliers, or cover other expenses. A cash flow shortfall could hurt sales goals, put a dent in marketing efforts, or in the worst case, cause a business to go under.
Why Profit Matters
It stands to reason that in order for a business to succeed, it has to be profitable on a continual basis. Profit is defined as the total revenue after expenses. Without it, a business owner may be unable to get a loan or secure investors. An unprofitable company can’t stay in business over the long haul.
Understandably, business owners are mainly focused on profit, but if that means they aren’t giving enough attention to managing cash flow it could spell disaster. It's particularly true if the business doesn't get paid on the spot. Waiting even a month for receivables could result in a negative cash flow situation for some businesses.
Smart Cash Flow Management is the Path to Profitability
To prevent such issues, businesses need to implement smart cash flow management strategies.
A solid strategy starts with being able to predict cash flow needs now and into the future. That doesn’t mean determining how much cash is necessary on January 1st and then ignoring it for the rest of the year. Demand ebbs and flows throughout the year, which impacts the amount of cash the business has on hand. A good rule of thumb is to predict how much cash is needed each month. Do that on a rolling 12-month basis to eliminate the likelihood of any surprises.
If a business owner can predict potential future cash flow shortages ahead of time, they can rein in marketing spending, hold off on paying a specific vendor, or seek alternative funding. Getting capital to bankroll daily operations requires time and planning. But preparation can prevent a scramble to figure out how to keep the business afloat when it is short on cash.
Create a Buffer with Cash in the Bank
In a perfect world, business owners would have enough cash in the bank to cover any surprise expenses. In the real world, countless enterprises are operating on shoestring budgets with little in the way of a cash cushion. Business owners should always be on the lookout for ways to build a cash buffer. That way, if they need to hire more staff or invest in technology they won’t be restricted.
For startups, that means actively talking to investors about raising funding. For those companies without access to investors, it means saving more money when times are good to cover expenses when business slows. Some business owners will take a percentage of their profits each month and deposit it into a separate business account they don’t touch. Others will take out a loan or line of credit they access only when they need it.
A Small Business Administration loan can be a good starting point. The U.S. federal government partners with banks and other lenders to offer these loans to small business owners. Because they are backed by the government, the lenders have more wiggle room in approving applicants. They can also offer better rates and terms with this loan product.
Renegotiate with Vendors
Many business owners wear multiple hats. They have little time to pay the bills, let alone pore over their vendor contracts. As a result, they tend to stay with the same supplier for years, even though there might be someone who can provide the same service better and cheaper.
In order to boost cash flow, it's important to periodically take a look at vendor contracts to see if there is a better deal to be had. It may not be a lower price, but it could be a longer billing cycle. For example: take an office supplies vendor that requires payment once a month. Extending that to sixty or ninety days can free up more immediate cash to fund operations. It also gives the business owner more time to set aside the money necessary to pay the vendor. Alternatively, if the bill is paid early, it could get the business a lower rate with the supplier.
While most vendors are trustworthy, there are some who may pad invoices with unnecessary charges or fees. Worse, a business owner could fall victim to a fraudulent invoicing scheme. To avoid that, business owners should check each invoice before paying, comparing it from one billing cycle to the next.
Healthy cash flow is the fuel required to drive long-term profitability. It helps the business weather any unexpected downturns, provides more opportunities to pursue growth, and shows investors and bankers the business owner has a deep understanding of his or her business. Without a proactive approach to positive cash flow, profitability will remain a far-off destination.