Most businesses focus on their net profit as the bottom line. But there’s more to a business than just its net profit. In fact, net profit is just one part of the equation when it comes to measuring business success.
It’s important to note that checking your bank balance is not the same as monitoring your cash flow. Your bank balance does not take into account outstanding payments and upcoming expenses.
Net Profit: What Is It?
Profit means different things at different times of the year. When you’re doing your taxes, you want to minimize the profit you show on your books. When you’re applying for a loan, you want to look as profitable as possible. Honesty first, of course, but there are grey areas in business expenses that can be used to offset your business income.
To calculate net profit, you start with the company’s total revenue. For most businesses, revenue is simply the company’s income generated from sales. Then you subtract all the company’s expenses. These include things like the cost of goods sold, operating expenses, and interest. The result is the net profit.
This number can give you a quick snapshot of how profitable a company is. It’s important to keep in mind, though, that net profit can be affected by one-time items, like the sale of a piece of equipment. So it’s not always the best number to look at if you’re trying to get a sense of a company’s overall financial health.
Net profit can be a helpful measure for comparing different companies or for tracking a company’s performance over time. In the example below, the company’s net profit is $20,000.
What Are The Limitations of Net Profit?
Net profit can’t, by itself, tell if you have enough income to support your business because net profit ignores principal payments on loans, distributions to owners, inventory, and equipment purchases.
In the example above, the company is profitable, but is the company going to have enough cash at the end of the year? If the owner takes a disbursement each month of $3,000, they will be receiving $36,000 in disbursements each year. Keep in mind the company is making $20,000 in profit for the year, so an extra $16,000 more will be withdrawn from the business than what was earned as profit. Therefore the company is profitable but operates in a Cash Flow Negative state. Eventually, this business will run out of cash.
Additionally, net profit can give you a distorted view of your business’s financial health. It can fluctuate from month to month or year to year, making it an unreliable metric for long-term planning.
Cash Flow: What Is It?
“Never take your eyes off the cash flow because it’s the lifeblood of business.” —Sir Richard Branson
You’ve probably heard the term “cash flow” before, but what does it actually mean? Cash flow is the sum of inflows minus outflows of your company. Keeping track of your cash flow is important because it can help you to avoid running into financial trouble down the road. By calculating your daily, weekly, or monthly cash flow and comparing it to your cash available you can determine how long your company can survive with its available funds.
To get started, take your net profit, which we calculated in the example above. Then you can calculate your cash flow which includes looking at your principal payments on loans and distributions to owners. See the continuation of our hypothetical business below.
In this case, the company is profitable, but unless it has a significant cash reserve, it will run out of cash. We can also determine when this company will run out of cash, otherwise known as their Runway. If the company starts with $50,000 of cash but has a negative cash flow of $24,000 then it will run out of funds in just over two years ($50,000 / $24,000). A Runway calculation is useful for companies with negative cash flows.
Runway = Available Cash / Cash Flow
This will give you a good idea of how much money is coming in and going out each month. From there, you can start to look for ways to improve your cash flow. For example, if you’re spending more money than you’re bringing in, you’ll need to find ways to cut costs or increase revenue.
On the other hand, if you have a lot of money left over each month, you may want to consider investing some of that money back into your business. Tracking your cash flow is an important part of running a successful business, so make sure to give it the attention it deserves.
How does cash flow differ from net profit, and why is it important to track it separately?
Net profit measures a company’s profitability. Cash flow, on the other hand, is measured on the total cash coming in and out of a company. It’s important to track cash flow separately from net profit because they can differ significantly.
For example, a company might have high net profit but low cash flow if it’s spending a lot on inventory or equipment. By tracking both net profit and cash flow, companies can get the complete picture of their financial health.
How can businesses use cash flow to make better decisions about their operations and investments?
Cash flow is one of the most important indicators of a company’s financial health. By tracking cash inflows and outflows, businesses can get a clear picture of their current financial situation. This information can be used to make informed decisions about operations and investments. For example, if a company is facing cash flow problems, it may need to cut back on expenses or raise money through new investments.
Conversely, if a company has strong cash flow, it may be able to reinvest those funds in new projects or expand its operations. In either case, businesses should use cash flow data to make informed decisions that will maximize their chances of success.
How to Get From Net Profit to Cash Flow?
Most small businesses can calculate their cash flow by taking the business’s net profit and making a few adjustments. The profit and loss will take into account revenue and expenses. To simply determine cash flow, you’ll need to adjust for principal payments on loans and distributions to owners. While there are other factors that may affect cash flow, this is typically sufficient for most small businesses. Once you’ve made these adjustments, you’ll have your cash flow for the period.
Are there any other factors business owners should consider when looking at their financial statements?
You should consider short-term variations in your net profit and cash flow to evaluate your business. Keep in mind that one-time expenses can have a significant impact on your company’s bottom line and cash.
Pinto has been helping businesses navigate the confusing world of net profit and cash flow to determine the financial health of their operations. By working with a trusted accounting professional, you’ll be well-informed and be able to make timely decisions to strengthen your business.