Many small business owners pay closer attention to the balance sheet and the income statement and forget about the cash flow statement. Unfortunately, most confuse cash flows and profits, which could lead to the failure of the business.
Both of these key metrics are important for your business. With one, you want to know whether you are making profits or losses. With the other, you want to know whether your business can stay afloat with the available cash reserves. Understanding the difference between these two is key to making crucial decisions for your small business.
It is what your business remains with after deducting expenses from your earnings in a particular period.
There are three types of profits to look at:
- Gross profit is the line item you see when you deduct COGS (Cost Of Goods Sold) from your income. COGS includes expenses you use to produce the goods you sell.
- Operating profit: it’s the net profit from your business operations. Unlike the net profit below, the operating profit does not include cash flows like interest and tax earnings and expenses. Basically, it doesn’t have funds from activities outside your core business.
- Net profit: also net income, is the best for showing your company’s profitability. It is what you remain with after deducting all expenses (COGS, interest payments, payroll, etc.), interests, and taxes.
It shows how many flows in and out of your business within a specific period. For example, think of the money you receive from sales, commissions, among others, and what leaves when meeting business expenses.
The net balance of these two activities is cash flow for that particular period. Your cash flow could be positive or negative. When you are operating on a negative balance, it simply means your money is paying more than what is coming into the business. It also means that your business doesn’t have enough cash reserves to meet its operations. This is a red flag.
There are three types of cash flows:
- Operating: it’s cash generated from the everyday operations of your business. You can use this as an indicator of whether your business operations are generating enough money to sustain its operations and growth.
- Investing: refers to money that your business generates from its investments, e.g., the sale of an asset or investments in marketable securities.
- Financing: it is cash flows from the money you use to fund your business activities. It includes funds you raise from debts and equity. Think of activities like borrowings from financial institutions and paying dividends.
To get a good understanding of your cash flows, look at the cash flow statement. I would recommend using accounting software. As long as you enter accounting items correctly, the cash flow statement will populate the correct movement of funds for whatever period you want to check. This is easier compared to doing it manually on Excel or Google documents.
Related post: Cash Flow Management for Small Businesses
What’s More Important?
Both profits and cash flows are important. When looking for ways to gauge how healthy your business is financially, you can not look at one of these and ignore the other. It is important that you understand how both of these work and their interaction.
Most small business owners pay more attention to their income statement and rest easy when they see they are making a profit. However, you shouldn’t wait until your income statement shows you are making losses to start acting.
If you have profits on paper, but your cash flow statement is negative, it means you are already in trouble. Similarly, you could make a loss but have a positive cash flow. For instance, maybe you borrowed money in that period, which affects the inflows of your business.
The bottom line, you should never take your eyes off these two. None matters more than the other. They are all critical when gauging the health of your business. However, these are not the only financial metrics you should pay attention to.