Cash Flow vs Profit: How to Pick Your Dime?

The longstanding debate between profits and cash flows is replete with subjective arguments. It is enough to perplex entrepreneurs and start-up owners on where to focus first. In truth, profits and cash flows are both essential stitches that hold the fabric of business together.

Entrepreneurs are best known as decision-makers. Starting a venture involves facing a plethora of dilemmas and stringing together decisions that best serve the enterprise. One such conflicting pick is between ‘cash flows’ and ‘profits’. While the two terms represent distinct concepts in accounting and finance, there is considerable overlap between the two in the business world. They are interdependent considerations and yet pose a trade-off in most cases. The first step in ranking the two on the priority list for a small business is gaining a clear understanding of both.

Cash flow vs profit

What constitutes cash flow?

The cash flow of a business venture is the net cash paid and received by the business. It is the result of cash that moves into and out of the business. The flow of cash can be positive in cases where receipts exceed payments, while it would be negative if the payments exceed receipts. Any business would usually attribute its cash flow to three main components—operating, investing, and financing. The operating cash flow arises from normal business operations; in essence, the business carried out by the venture. The investing cash flow is attributed to cash flow that arises from the firm's investment activities, such as returns earned on investments, rent earned on machinery leased out, etc. On the other hand, the financing cash flow comes from investments made in the venture or credit availed by the venture.

What constitutes profit?

Profit is the financial gain of the business. Specifically, the reward earned for carrying out operations. It is affected by intangibles such as business environment, economic conditions, decisions made at the firm, and the cost and revenue model followed. Profits are usually considered the yardstick of a venture’s success; they carry weight in judging the future of the business. Profits are a factor considered in investor decisions; they serve as the base for tax assessments and often form the crux for determining creditworthiness.

Understanding the difference between cash flow and profit

It becomes evident that cash flows resemble the fuel that runs the business, while profits are analogous to the destination. Since cash flows and profits are intertwined, it becomes essential to understand that despite being different business concepts, they are not independent. Rather, the choice between prioritising the maintenance of cash flows and swinging profit margins is a trade-off at best. Increasing profit margins may demand investments in equipment, resulting in greater efficiency that is bound to bring down the investing cash flow. Similarly, resorting to placing bulk orders of materials to reduce costs may in fact increase the storage costs. Alternatively, aiming for better cash flows may necessitate adopting a policy that allows minimum credit sales, which may cause the business to lose a chunk of its customers, impacting profits and sales volumes. The quest for improved cash flows may also prompt a business to avail greater amounts of short term credit, which would increase the interest payable, adding to the costs of the firm that culminate in reduced profits.

Revenue recognition principle

The inherent difference in the realities of choosing between profits and cash flows stems from the accounting principles of accrual and revenue recognition. The revenue recognition principle using accrual accounting follows that revenue is recognised when it is realised and earned and not when the corresponding cash amount is realised. In a nutshell, establishing a transaction that contributes to revenues or costs does not necessitate the exchange of funds or cash, but is governed by the concept of liability to pay and receive. This principle seeks to separate revenues and costs from cash or funds, implying that it's possible to incur costs without spending cash. At the same time, it’s also possible to earn revenues without earning cash. Every element of incurred cost merely generates the liability to pay, while every element of revenue accrues the liability to receive.

The difference created by the revenue recognition principle between the receipt of funds and incurring costs or accruing revenues leads to two underlying consequences. Firstly, there may be different cycles or appreciable time lags between earning revenues and incurring costs. For instance, the venture may receive funds corresponding to its revenue long after the revenue has been accrued, which only delays and disturbs the cycle for making payments to the suppliers of the venture. Secondly, there remains an element of risk associated with realising any accrued revenue. In such cases, defaults on receiving payments hamper cash flows that affect the firm's ability to make payments.

Cash flow and profit in practice

The search for a single metric of reliance to judge the performance of a business gives rise to the longstanding debate between cash flows and profits. It throws an entrepreneur’s priority list under question. While the choice isn’t as easy as picking between heads and tails while calling a toss, certain contemplations may lead one to a reasoned out, informed decision. Both cash flow and profits are pertinent to the long-term success of any venture; however, it may be wise to focus on one over the other.

While a business starts out, managing cash flow is rationally the first order of business. In the initial stages of business, credit operations usually constitute a lesser proportion of transactions given that creditworthiness is yet to be established and goodwill yet to be earned. Managing preliminary expenses demands tactful handling of funds. Furthermore, although most businesses operate with profits as their ultimate goal, it becomes imperative to understand that there is a significant lead time that must elapse till the business begins to achieve a breakeven stage and then gradually progresses to earn profits. Efficient cash flow management is of the essence while the business absorbs its initial phase of losses.

Another important consideration to make while choosing between cash flows and profits is the type of industry the venture operates in. A novice firm that undertakes manufacturing activities is likely to require greater amounts of working capital that necessitate efficient cash flow management. Seamless management of cash flows serves as a prerequisite to seamless conduction of operations, ultimately leading the business on the path of profitability. A trading concern or a firm from the service sector may be able to carry out business with lesser working capital. This means that cash flow management would demand lesser attention, allowing the entrepreneur to build a revenue model that prioritises profits.

In Essence...

The tiff between cash flows and profits is a decision laced by conditions that are subjective to every venture. While it can be said that cash flow management is the lifeblood of any business and profits, the healthy outcome, it cannot be denied that one does not guarantee the other.

We bring to you such topical and pertinent debates abound in the business world. Browse through OKCredit Blogs for more insights into the world of business.  

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1) Best Tips for Customer Retention for a Small Business
2) Tips to Understand Your Market while Starting a Small Business
3) Tips for Businesses to Overcome the Covid Blues - Revival Tips for Businesses
4) What are the keys to success when operating a small scale business?
5) OkCredit: All you need to know about OkCredit & how it works.

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FAQs

Q. What affects cash flows?

Ans. The gap between receivable and payable accounts is the root of mismatched cash flows. The credit policy, receivables management policy, investing and financing decisions, and the patterns of working capital management and acquisition are factors that influence the cash flows of a venture.

Q. Does higher profit ensure better cash flow?

Ans. Higher profits from business operations may not necessarily contribute to better cash flows. This depends on the policy adopted by the business for managing receivables and payables. Larger sales volumes based on credit may increase the profits earned, while they will simultaneously tie up funds in receivables, which may not be immediately realised.

Q. How do cash flows affect costs?

Ans. Poor management of cash flows may prompt a venture to avail greater amounts of short-term credit which contributes to interest payable by the venture. Proper management of receivables and payables may minimise the need for short-term borrowings. In essence, poor cash flow management may contribute to increased interest costs.

Q. Poor cash flows or low profits: what causes more harm?

Ans. According to a bank study undertaken in the United States of America, almost 82% of ventures fail due to poor cash flow management, allowing funds to be tied up in receivables. Businesses can’t survive in their initial stages even if they manage to break even. Poor cash flows are more likely to draw a shutdown than reduced profits.