The amount of money currently or expected to be available is known as cash. Cash serves as a resource to pay expenses and it is the money received from either the investors or direct business activity. Profit on the other hand refers to the money left after all expenses are paid. A successful business would need to operate with positive cash flow as well as achieving profits in the long term. Although the two terms are of different financial parameters, a solid system to keep track of both is needed for a business to thrive. Hence, it is prudent to understand that both cash and profit are crucial aspects of a business. A common analogy in business is that cash is like oxygen which is needed constantly to survive. In contrast, profit is like food whereby without it we can live for a while but it must be eventually replenished to survive (Fulmer J.G., 2002).
Functions of Cash
Cash and profit have different functions. Cash flow revolves around the inflows and outflows of cash in a business. Profit on the other hand is referred as net income and defined as revenue less expenses. An immediate increase in cash is not always determined by earning revenue and an immediate decrease in cash is not always due to an incurring expense (Rosemary Peavler, 2019). The reasoning is that a cash flow statement is the actual report of the business itself whereas profit does not reflect the cash in the business although it might show up on the papers. Cash is the key indicator of financial health and essentially the lifeblood of a business. Poor cash flow management could destroy a business as cash flow determines viability and not profit. Thus, companies need to understand the importance of actively managing its cash flows as well as the ability of managing its cash to succeed.
Importance of Cash and Profit
The importance of bringing cash into the business is often described by the adage “cash is king” (Charles Schwab, 2006). The key metrics of assessing the availability of cash is by analysing both the cash flow and cash position. Current level or value of cash accounts is associated with cash position in comparison to the pending expenses and debt repayment obligations. A strong cash position saves up money left for safety, dividends or reinvestment besides helping in the payment of bills. Over the time, changes in net cash could be observed in the company’s cash flow statement. Improving cash flow means the company’s collection of cash accounts would be better in maintaining a stable and improved cash performance in the future. Companies usually focus in making the most profits possible as their long-term financial objective. Operating profit, gross profit and net profit on the company’s income statement gives a glimpse of the credibility of earning income from either the sales of goods or services (Glassman, J.K., 2012). In fact, generating strong revenue through effective marketing and solid offerings besides controlling costs through efficient use of resources would optimise the profits. A business could achieve its financial goals by earning profits and further achieving income to reinvest for the company’s growth.
Relationship between Cash and Profit
A link between cash and profits could be seen from the accounts receivable and accounts payable. Money earned but yet to be collected from the customer is shown in accounts receivable. Profit improves through revenue on accounts but cash flow is inhibited as there is no cash in hand immediately. Sometimes, receivables uncollected are written off as a bad debt affecting both cash and profits. In contrast, accounts payable refers to the money owed to the creditors for supplies and materials. Owing money actually improves short-term cash position while minimizing profits. It is important to take note that cash flow and profits are not completely synonymous although both are related (Osgood, W.R., 2020). Cash flow calculations gives an ongoing understanding on the monthly financial situation by monitoring receivables and payables so that operating business is on track from day to day. Profitability on the other hand gives a general overview of business finances in a bigger picture through accounting. Therefore, planning ahead for gaps between accounts payable and accounts receivable through a step-by-step cash flow analysis would provide the necessary cash flow needed to invest wisely.
Conflicts of Cash and Profit
Ideally a company generates plenty of cash and profits but both financial objectives do have conflict sometimes. This is because short-term profit has to be sacrificed when decisions to maximise cash flow is taken whereas ambitious profit objectives may come at the expense of near-term cash flow (Troy Morgan, 2015). A company would not survive no matter how great the product or business model is if the company’s cash is not managed efficiently. It is observed that small-to-medium businesses constantly reinvest profits into the operation causing the business to be of higher risk of being cash poor. Larger businesses on the other hand are more established and tend to have cash reserve.
Let us analyse and assess a scenario for an example. What happens when the closing balance adds up to be lower than the starting balance resulting in a negative cash flow? Well, it is important to firstly understand that business can have positive cash flow without making profit and a business could also be profitable without being cash flow positive. Negative cash flow could mean poor timing of income and expenses or that the business is losing money. The goal is to keep the business afloat in negative cash flow situations as a business cannot sustain with a long-term negative cash flow.
In conclusion, the ultimate goal in a business is to have more cash coming in than going out. Regardless of the profits reported, companies should keep in touch with the cash aspect of the business. Operations will simply cease if the business goes out of cash. Worst case scenario, insufficient cash flow in a profitable business could result in bankruptcy. The vision for a business to prosper is to start a business whereby cash flows are the day-to-day driver while profitability helps the company to grow (Samantha Novick, 2017). A business can be comfortably expanded to a more profitable business as long as there is enough cash to survive. Hence, a business decision should be considered after having a thorough understanding of the company’s cash situation since cash flow is the real bottom line in a business and not profits.
- Charles Schwab: Cash Flow vs. Earnings – Which is More Meaningful: Greg Forsythe: September 2006.
- Fulmer,J. G., Jr., Finch, J. H., Smythe, T. I., Jr., & Payne, T. H. (2002). Growing sales and losing cash: Assisting your small-business customer with cash flow management. Commercial Lending Review, 17(4), 14-19.
- Glassman, J.K. (2012). Go With the Cash Flow. Kiplinger’s Personal Finance, 66(8), 16-18.
- Osgood, W. R. (2020): Common Sense Cash Flow Management. Strategic Management Learning System Workbook 1, Knowledge Institute, Inc.
- Rosemary Peavler: Are a Firm’s Cash Flow and Profit Different? They are different, but both are important. The Small Business.com: January 2019.
- Samantha Novick: The difference between cash flow and profit explained: June 2017.
- Troy Morgan: The Mystery: Why Profit doesn’t Equal Cash in the Bank: January 2015.