Are a Firm's Cash Flow and Profit Different?
Cash Flow and Profit Are Different, but Both Are Important
Cash flow and profit are two different financial parameters, but when you're running a business you need to keep track of both. Here's how they're different, why they're both important and how they intersect with other corporate issues, especially when a company grows rapidly.
Cash flow is the money that flows in and out of the firm from operations and financing and investing activities. It's the money you need to meet current and near-term obligations.
But there are two things to keep in mind about cash flow:
- A business can be profitable and still not have adequate cashflow. In the worst case, insufficient cashflow in a profitable business can send it into bankruptcy. For example, you're making widgets and selling them at a profit. But your product goes through a long sales chain and some of your biggest and most important wholesale customers don't pay on invoices for 120 days. This sounds extreme, but many large US corporations in the 21st century don't pay an account payable for three or four months from the receipt of the invoice. Since you're the little guy, the suppliers of materials you need to make those widgets often want to be paid either upon receipt or in 15 or 30 days. Ironically, if you're caught between suppliers who want their money now and buyers who're slow to pay, a successful product with increasing sales can create a real cashflow crisis. Even though your unit sales are increasing and profitable, you won't get paid in time to pay your suppliers and meet payroll and other operational expenses. If you're unable to meet your financial obligations in a timely way, your creditors may force you into bankruptcy at a period when sales are growing rapidly.
- Your sales may be growing and the money keeps pouring in, but that doesn't mean you're making a profit. If you borrow money to solve the cashflow problem, for instance, the rising debt costs that result can raise your costs above the breakeven point. If so, eventually your cash flow will dry up and eventually your business will fail.
Profit, also called net income, is what remains from sales revenue after all the firm's expenses are subtracted. It's obvious in principle that a business cannot long survive unless it is profitable, but sometimes, as with cash flow, the very success of a product can raise expenses. It may not be immediately apparent that this is a problem. In other cases, you may be aware of the problem, but believe that by reducing production costs you can restore profitability in time to avoid a crisis. Unfortunately, unless you have a clear understanding of all the relevant cost data, you may not act effectively or promptly enough to make the firm profitable again before it runs out of money.
Rapid Growth and Business Failure
It turns out that rapid growth can lead in several ways to a business failing. The cashflow problem described here is one cause, where suppliers require rapid payment of invoices while wholesale customers pay slowly. The profit problem described above is another: increases in production volume drive up costs beyond the breakeven point. A 2013 American Express article on the rapid growth problem describes five more contributory issues, all of them affecting cashflow, profit or both:
- Operational problems: volume increases change operational requirements. Often, businesses in the midst of a growth spurt devote insufficient time to making those changes in time,
- Customer service issues: new products spur sales, but often come with issues leading to expensive warrantee repairs or even product recalls. A customer service staff may not expand in concert with sales growth, which also leads to customer dissatisfaction,
- Exuberant corporate spending: the success of one product may lead the company to make overly-optimistic spending decisions, such as expensive equipment purchases and imprudcent facilities improvements
- Human resource problems, including a rapid influx of workers unfamiliar with or unsympathetic to the existing corporate culture; dissatisfaction of current staff over new supervisors, payroll problems and changes in production methods
- Leadership problems: often the characteristics of a successful entrepreneur are quite different from the characteristics of a successful CEO of an established company. As a company expands beyond its startup phase, it may require a change in leadership, which is either resisted or unrecognized in a timely way.
In a growing company, keeping track of cashflow and profit also requires attending to these related issues. Sometimes it may even become necessary to curtail the growth rate in order to assure long-term success.
See these articles:
- How to do a Step-by-Step Cash Flow Analysis
- Definition of Cash Flow
- How do you Determine Profit or Net Income?