Pop quiz! What’s the difference between cash flow and profit? If your hands got a little sweaty and you found yourself searching for the nearest pencil sharpener so you wouldn’t need to make eye contact with anyone who might ask you to understand, we get it. As a business owner, these 2 terms can feel awfully interchangeable. But the truth is, they’re far from it—and knowing when to prioritize one over the other can help you make better strategic decisions in that moment. How do you know when to prioritize cash flow or profit? Ack! Another question. Okay, so let’s say you started a business 3 years ago and took on some loans from investors to help you get off the ground. Unfortunately, the pandemic hit—along with record-level inflation—and you haven’t been able to pay back your investors as quickly as you’d like. Now, they’re starting to pressure you for a return. Would you focus on cash flow or profit in this situation? Prioritizing cash flow will offer you more fluidity with debt repayment and should come before profit in this scenario—but don’t worry if you didn’t know that, yet, because we’re going to explain all of this and then hit you with that quiz we promised. So sit back and get ready to understand the difference between cash flow and profits and when each is most important. What Is Cash Flow? Whether you’re just starting a business or have an established brand, you’ll feel the effects of cash flow similarly. Cash flow is simply the movement of liquid money (cash) in and out of your business at a specific point in time. When you execute a business transaction and receive money, that’s an inflow of cash. When you spend money on inventory, bills, or other expenses, that’s an outflow of cash. As you track the movement (flow) of cash in and out of your business, you’ll find that you are either operating: Cash Flow NegativeCash Flow PositiveYou’re spending more cash than you’re bringing in.You’re bringing more cash in than you’re sending out. If you have positive cash flow, you have enough cash to cover your financial obligations. If you’re operating with negative cash flow, you are not bringing in enough cash to cover your current expenses and will likely need to seek additional business financing to continue running at your current pace. What Is Profit? Profit refers to the remaining revenue after all expenses are paid. If you have a positive value after subtracting total expenses from total revenue, then you’re profitable. If you have a negative value, you’re spending more than you’re making over that timeframe and are operating with a loss. Profit can be used in many ways. You can distribute profit to other owners or shareholders, invest it back into the business, or save it in a reserve fund in case of emergency. For many small businesses, profitability fluctuates throughout the year. Take toy and hobby retailers, for example, which arguably see the bulk of their sales in the final quarter of each year. This imbalance creates cyclical ebbs and flows of profitability r, which can be misleading without the proper context. (source) What’s the Difference Between Profit and Cash Flow? Cash flow and profit are just 2 of many financial metrics business owners and investors use to assess the health of a company. Both measurements have their own advantages and disadvantages, and it’s up to you to understand how to use each to make better strategic decisions. However, the difference between profit and cash flow can be tricky to grasp because they both relate to the balance of money within your business. Complicating the matter further, businesses can actually operate with a positive cash flow without being profitable—and may be profitable with a negative cash flow. Timing is the subtle difference that needs to be considered when comparing cash flow to profit. Cash flow focuses on the past, looking at the actual money that has come in or left your business at a specific point in time. Profit looks at the past, present, and future of your business and includes liabilities like accounts receivables and long-term debt, which are expected expenses or future cash. For example, if you sell an item on credit, you don’t actually have the cash on hand—it’s an account receivable, which still needs to be collected. However, it’s considered revenue because the liability of payment has passed on to your customer, and it is used to measure profitability. On the other hand, cash flow will only measure money that comes in and leaves your business. As a result, it won’t recognize that transaction until the cash is received from the credit purchase. When to Prioritize Cash Flow or Profit Cash flow and profit both have their purposes as financial metrics, and business owners would be wise to measure and analyze each ongoingly and for different scenarios. For example, if you want to have an overarching view of your business and its long-term viability, profit can shed more insight than cash flow because it takes a holistic view of your income and financial obligations. However, if you want to see a snapshot of your financial efficiencies at a specific point in time, cash flow may give you more perspective because it’s focused more on your day-to-day operations. Quiz Time: Now, It’s Your turn. We’ve outlined the difference between cash flow and profit as well as when each is most important. So, let’s take a look at a few scenarios and see if you can apply this understanding to real-world examples. At the end of the quiz, we’ll see how you did. Question 1: Your Restaurant Recently Purchased a Food Truck to Diversify and Scale The food truck industry has grown 148% since 2020, and many established restaurants are joining the fun and starting their own food trucks as another channel to help grow their revenue and brand. If you own a restaurant and recently decided to purchase a food truck, you are making a large financial investment in the future of your business. Launching a food truck costs roughly $50,000−$60,000. To cover the purchase of the food truck, let’s say you took on a 5-year equipment loan, which ends up being roughly a $942 monthly investment (equipment financing calculator). What’s more important to your business right now? Cash FlowProfit ANSWER: In this scenario, cash flow would be more important than profit. By purchasing a food truck, you’re making a long-term investment. The goal should not be making an immediate profit on the $50,000−$60,000 food truck—that’s simply unrealistic. Instead, your focus should be on operating with a positive cash flow so that you can pay for your gas, ingredients, labor, the $942 monthly interest payment, and any other expenses or debt that you have. It will take time for you to see a positive ROI on the food truck, so your priority should be paying your short-term expenses and maintaining positive cash flow so that you can sustain the food truck long enough to eventually recoup the investment and turn a profit. Whether it’s a restaurant investing in a food truck or any small business purchasing new equipment to help for future success, the upfront investment is often more expensive than any immediate return—meaning profit or breakeven on the investment is unlikely for a long time. In these situations, it’s best to prioritize cash flow and maintain consistency with your day-to-day financials so you can operate your business long enough to see a positive ROI. Question #2: Your Construction Company Is Completing a Job With Net-45 Payment Terms If you run a construction company, you’re probably familiar with net payment terms. Net payment terms means your business takes on the expenses and financial risks needed to complete a job with the expectation of receiving payment within a specified window after the job is finished. With net-45 terms, you will be paid sometime within 45 days after completing the job. Your business will spend all the money (cash) needed to complete the job—materials, equipment, machinery, and labor—but will not recoup that money (cash) and any profit until it’s paid sometime within 45 days after you’ve finished. Additionally, the revenue you earn from this work is fixed and agreed-upon prior to starting the project, which means you have a cap on your earnings. What’s more important to your business right now? Cash FlowProfit ANSWER. In this scenario, profit is more important than cash flow. Your business will operate the length of this contract with a negative cash flow and will only stand to earn a profit once the contract has closed—sometime within 45 days after completion. You need to complete the job for less than what you are charging the client to turn a profit or you will finish the contract with a net loss. Fortunately, you know how much you are to be paid once the job is completed—so you should focus on keeping your expenses down throughout the job to ensure that you’re able to earn a profit once it’s completed. Whether you run a construction business with net payment terms or another contract-or-service-based business that completes projects before collecting payments, the focus should be on profitability, not cash flow, as you work to complete each individual project. Question #3: You’re Opening a Brand-New Laundromat Business You finally decided to take a chance and start your own business—a laundromat in your hometown. You did all the research, created your business plan, found the perfect location, bought all the required equipment, hired a great team of employees,and took out a startup loan to cover the investment. Now, you’re finally ready to open your doors. By this point, you’ve taken on a huge financial risk and are hopeful that you can grow the business and repay all your debts while also bringing in a reliable income for yourself in the meantime. What’s more important to your business right now? Cash FlowProfit ANSWER: In this scenario, cash flow would be more important than profit. You’ve made a commitment and are taking on the financial investment to start your own business, but now you need to focus on keeping it open and growing. Cash flow is the metric that is most concerned with the day-to-day financials and short-term operations, which is why your focus should be on cash flow and not profit. Of course, you should ensure that you’re still operating profitably month to month, but you should be most concerned with bringing in enough cash to cover your current obligations. If you aren’t bringing in enough cash to cover your rent, utilities, payroll, debt repayments, and other expenses, you won’t be able to keep your doors open long enough to see a return on your full investment. For any new small businesses, cash flow is critical. In fact, a recent study found that 82% of small businesses that failed cited cash flow management as the main cause. Cash flow is so important to new businesses because: They don’t have cash reserves: Established businesses tend to have more flexibility than startups because they often have cash reserves available to pull from as needed.It’s harder to get additional funding: New businesses may lean on financing to open their doors, but if they need additional funding, it can be more difficult than established businesses because they haven’t built trust yet with lenders and haven’t met the 2-year requirement for many small business loans.It’s hard to get customers as a new business: It costs about 500% more to acquire a customer than it does to keep one, and as a new business you have to acquire every customer. New companies often struggle with cash flow because it’s simply harder to get customers, especially if you’re in a highly competitive market. How Did You Score? If you answered all 3 questions correctly, awesome. If you didn’t, it’s okay—understanding the difference between profit and cash flow can be tricky. Regardless of how well you did on the quiz above, you’re on the right track if you made it this far because you’re serious about making better strategic business decisions. The rub to understanding when to prioritize profit or cash flow is really based on your current financial health. If you’re in a stable financial situation where you’re not struggling month-to-month, then your focus should turn to strategies that will make your business more profitable (not necessarily short-term profitability). BTW, if you’re not using a tool that will help you with tracking both cashflow and profit, try the accounting tools from Lendio. Not only will they help you keep tabs on everything while also automating the process, they’re also free to use. Plus, you can take ‘em anywhere with the mobile app, too. However, if you’re concerned about covering bills, debt, and other liabilities, you need to be bringing in more cash right now to cover those expenses. This short-term focus lends itself best to a more cash-flow-oriented approach. Cash Flow or Profit: What’s More Important? Cash flow and profit are both important, and business owners and investors may focus on each at different times and for specific reasons. Determining whether profit or cash flow is more important will be based on your unique situation. Understanding the relationship between cash flow and profit can help you begin to identify when to look at one or the other. This insight alone will put you in a better position to make the right decisions to guide your business forward.