Many entrepreneurs think that their businesses will survive as long as they are able to make profits. The fact is that profit alone cannot ensure guaranteed success. Business stability generally depends on the cash flow, which describes the movement of cash coming in and going out.

There is a difference between profits and cash flow. The former represents the financial gain. It reflects that the sales you made are higher than your annual expenses, while the latter represents the liquidity available for day-to-day expenses. Many entrepreneurs think that the whole profits are liquid, meaning you can use all of them for day-to-day expenses.

Do not forget that profits include non-cash items such as depreciation and revenues yet to be received. However, cash flow only tracks the actual money that your business has. It measures liquidity. The exact amount of cash flow determines whether you will be able to survive your business when profits decline.

It is worth noting that a company can be profitable despite a negative cash flow. Here are the reasons why a profitable business can face a cash flow shortage because of the following reasons:

Understanding cash flow

Cash flow is necessary for daily expenses. Whether you want to purchase inventory and pay employees, you must have a steady source of cash. This is essential to meet all kinds of operational overheads. Cash flow can be generated in the following ways:

§  Operations: this money is related to the production and sale of goods and services. This is a direct contributor to cash flow.

§  Investing activity: This money is related to investments you make. When you invest in assets, you will be able to generate some returns, contributing to cash flow.

§  Financing: this includes money related to dividend payments and the issuance of corporate bonds.

Cash flow can be positive and negative.

§  A positive cash flow indicates that there is more money coming in than going out. It means the company’s liquid assets are growing. You will be able to settle debts easily, reinvest in business and pay dividends to shareholders. A positive cash flow ensures that you can easily meet all your day-to-day expenses. In fact, this makes it possible for your business to meet unexpected financial challenges.

§  A negative cash flow indicates that liquid assets are rapidly decreasing. It indicates that money is going out more than coming in. It might be due to excessive debt and delayed collections from accounts receivable.

A negative cash flow can be problematic for many businesses as it threatens their ability to deal with day-to-day expenses. However, it is not always a negative sign. If you are a start-up, it is common to have a negative cash flow. This is because you are investing money in your business growth. You might be relying on quick business loans with no credit checks in the UK to cover your business expenses until you reach the breakeven point.

Understanding profits

Profit is the surplus that you are left with after paying all of your expenses from the revenues you earn. Taxes are calculated on the surplus.

There are three types of profits:

§  Gross profits

Gross profit is the amount of money that you are left with after deducting the cost of goods sold. Gross profits indicate how smartly you manage your production costs.

§  Operating profit

Operating profit is a form of profit that is derived after deducting operating expenses from gross profits. This ensures operational efficiency.  

§  Net profit

Net profit is called net income. This is determined after deducting taxes and related expenses from gross profits.

It is vital to understand the difference between each type of profit. You will be able to better understand the true financial picture of your finances by knowing the exact amount of profit.

Ways to manage cash flow in a small business

Here are the ways to manage cash flow in a small business:

§  First off, you should keep accurate records. It is critical when running a business. You have a record of all unpaid invoices. Make sure that you get them paid regularly. They should be paid before accounts payable are due. Have all documents ready. If you are struggling with handling them, you should use accounting software.

§  Plan ahead. You should have an idea of what contingencies can crop up down the line. This will help you earmark some cash. It is crucial to have an earmarked cash to meet financial obligations when unexpected expenses crop up. Once you find that cash flow is problematic, you can immediately take steps to fix it.

§  Keep your business and personal finances separate. This will help you know an exact figure of cash coming in and cash going out. Your accountant can better inform you of your cash flow position.

§  Build a cash reserve. You should carefully build a cash reserve. Earmarked cash will help you furnish cash when unexpected expenses crop up.

§  Regularly update your cash flow forecast. Closely monitoring your cash flow is a must because this helps you understand how to make the right strategies.

The bottom line

Cash flow is more important than profits for all types of businesses because the former reveals liquid cash that you will need to meet day-to-day business operations, while the latter reveals your profitability.

In order to make your business successful, you should focus on both, but there could be times when profits are compromised due to uncontrollable economic factors. Make sure that your business has enough cash to meet them.