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When you hear that a business is “profitable,” it’s easy to assume that it’s smooth sailing when it comes to finances. However, profitability is only one measure of a business’s financial health. Without sufficient cash flow, even profitable businesses can struggle to make ends meet, and may even be forced to close shop.
In this brief overview, we’ll define cash flow and profit, identify the difference and discuss the importance of both for any entrepreneur.
What’s the difference?
First, let’s define cash flow and profit, and what differentiates the two.
Cash flow is all of the money that flows in and out of your business, and the timing at which it does so. It’s a more dynamic measurement than profit, which simply equals a business’s overall revenue minus its expenses at any given point in time.
Profit tends to be a high level way to evaluate how a business is performing over time, while cash flow is more temporal and concerned with business operations on a day-to-day basis.
This matters because profit, while critical to a business’s overall success in the long term, may not be an accurate predictor of a business’s ability to keep its doors open in the immediate future.
As a business owner, it’s insufficient to estimate your annual profit, even if done with perfect accuracy. In order to ensure you don’t find yourself in a bind over the course of the year as your income and expenses fluctuate, you’ll need to predict and plan for your cash flow needs in advance.
A closer look at cash flow
Predicting your cash flow requires you to identify your sources of income and when they will come in, as well as to understand your expenses and when they’ll need to be paid.
It’s important to consider cash flow in the context of a number of factors, from operational costs like rent and payroll, to seasonal fluctuations, to debt financing and repayment schedules. In order to keep your business solvent, you’ll need to ensure that you have enough cash on hand to pay down your expenses on time.
If, for example, you’re a clothing designer, seasonal considerations, large upfront costs and delayed repayment are all important (and tricky) factors to manage when it comes to controlling for your cash flow needs.
Let’s imagine a simplified model in which our designer produces her spring line of clothing at a cost of $20,000, and is able to make $35,000 in sales. On its head, it looks like a neat profit of $15,000. If, however, she needs to repay her costs within the month, but won’t receive payment on the sales invoice for 30 to 90 days, she may be in trouble unless she has cash reserves set aside to tide her over in the interim.
Delayed payments are only one common cause of cash flow issues. Others might include lower than expected profits, an unexpected expense such as repairs on essential equipment, or a flurry of expenses related to employee benefits that all come due in a short timeframe. If you feel your business is facing a money crunch, you may want to consider a form of cash flow finance to fill the gap.
The best way to understand and manage cash flow is to be prepared. As a business owner, it is essential to align your startup’s budget with your calendar, and keep a close eye on any serious shifts.
It’s recommended that you perform a cash flow analysis at least once a month and begin to pay attention to trends to avoid being blindsided by any potential shortcomings.
By thinking holistically you can predict when cash may be tight, and strategically redistribute expenses over the course over the year so that your profitability can prevail.