Profit vs Cash Flow. What\u2019s the difference?<\/p>\n\n\n\n
As a founder CEO, understanding the difference between profit and cash flow is critical. If you don\u2019t, it shows you don\u2019t understand finance, you don\u2019t understand GAAP, and you aren\u2019t a sophisticated steward of capital. Investors will notice. Your CFO will notice. Your business may suffer.<\/p>\n\n\n\n
In this article, I\u2019ll break down the two metrics, how they differ, and why both are important. Let\u2019s dig in.<\/p>\n\n\n\n
Cash flow is intuitive and readily observable. At its core, cash flow is the change in a company\u2019s cash position over time. If your cash sits in one or more bank accounts, measuring it is as simple as measuring the change in those balances from period to period.<\/p>\n\n\n\n
So why can\u2019t we just stop there? Isn\u2019t cash flow all that matters. Isn\u2019t it enough to gauge business performance?<\/p>\n\n\n\n
To be sure, cash flow is a critical metric. Part of what makes it useful is its simplicity and finality. Afterall, cash is king. If your business doesn\u2019t generate cash over a reasonable time horizon, then it\u2019s probably not a very good business. <\/p>\n\n\n\n
But cash flow, while simple to measure, can be a very noisy signal of business performance. The biggest issue is timing. <\/p>\n\n\n\n
Cash flows depend on when<\/em> your customers pay you and when<\/em> you pay your suppliers. <\/p>\n\n\n\n If you\u2019re a B2B SaaS business, this might work to your advantage. Your customers pay you upfront for a one-year subscription, so you get a lump of cash which you can use to fund payroll and compute. <\/p>\n\n\n\n If you\u2019re an e-commerce company, it might be the opposite. You pay suppliers for inventory well in advance of selling your product and getting paid by your customers. <\/p>\n\n\n\n Either way, there\u2019s a lumpiness to cash flow that makes it an imperfect tool for assessing business performance over shorter time horizons.<\/p>\n\n\n\n Let\u2019s look at the two companies again.<\/p>\n\n\n\n Suppose you\u2019re a B2B SaaS business that\u2019s in decline. You look at last quarter\u2019s cash flow and it\u2019s positive because you happened to collect a large upfront renewal from one of your remaining customers. Meanwhile, your sales team isn\u2019t hitting quota. Your renewal rates are generally low. You\u2019re being outcompeted and you know it. Cash flow is in the green, but it tells you nothing about how your business performed.<\/p>\n\n\n\n Now suppose you\u2019re an e-commerce company growing quickly. You look at last quarter\u2019s cash flow and it\u2019s negative because you stocked up on inventory ahead of the holiday season. You\u2019re expecting revenue to grow 100% this year. You just landed three new wholesale accounts. Cash flow is in the red, but once again, it tells you nothing about how your business performed.<\/p>\n\n\n\n What these examples illustrate is that cash flow isn\u2019t the full story. Clearly the lumpiness of cash flows can distort the picture of how your business is performing. So how can we adjust for this lumpiness and timing issues?<\/p>\n\n\n\n The answer is GAAP accounting, otherwise known as \u201caccual-based\u201d accounting. <\/p>\n\n\n\n You don\u2019t have to be a CPA to appreciate and understand GAAP accounting. In essence, GAAP is a set of rules designed to give you more insight into how your business is performing over shorter time horizons. Think of GAAP as a set rules for how to smooth out the lumpiness in cash flow.<\/p>\n\n\n\n Let\u2019s go back to our examples<\/p>\n\n\n\n If you\u2019re a B2B SaaS company with lumpy, upfront customer payments, GAAP rules tie revenue to when you deliver<\/em> the service rather than when the customer pays. Under GAAP revenue recognition rules, you divide the upfront payment over the life of the contract and recognize it beginning on the subscription start date. If you renew a customer on a one-year, $120,000 contract starting January 1, then you recognize $10,000 of revenue per month for twelve months starting in January.<\/p>\n\n\n\n If you\u2019re an e-commerce company with lumpy, upfront supplier payments for inventory, GAAP says to recognize the cost of each unit sold when it\u2019s sold<\/em>, as opposed to recognizing the total cost of inventory when you paid the supplier. In this way, GAAP is matching the cost of goods sold to when you recognized revenue.<\/p>\n\n\n\n A key principle of GAAP is to ignore when a payment is made and instead focus on when services are rendered.<\/p>\n\n\n\n Let\u2019s say you hire a contractor on a project. You agree to pay the contractor $15,000 and the project takes two weeks in August. Now suppose the contractor doesn\u2019t send you an invoice until September and you don\u2019t make payment until October. Obviously the payment will hit cash flow in October. But GAAP looks at when the services were rendered, so you record the expense in August.<\/p>\n\n\n\n In the examples above, notice what GAAP does. It moves the revenue and expense into the period where the economic activity actually happens as opposed to when cash is received or paid. <\/p>\n\n\n\n When you put all of the GAAP rules together, you get a very different financial picture of your business. This picture is called the Income Statement, otherwise known as the Profit & Loss Statement, or P&L for short.<\/p>\n\n\n\n Using the P&L, a business is able to record revenue and expenses in the period the economic activity actually happens and calculate its profit, typically on a monthly basis. Apply the rules consistently and completely across all the different types of cash flows, and the P&L will give you real insight into performance. By smoothing out and lining up your revenue and expenses, you can start to look at profit margins and assess profit trends from month to month.<\/p>\n\n\n\n Profit comes in several different forms in practice. A typical P&L will show gross profit, operating income, and net income. Many companies and investors also track EBITDA, which is Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA can be calculated from the P&L in most cases.<\/p>\n\n\n\n Over a long enough time horizon, cash flow and profit should tell the same story. Cash flow lumpiness eventually evens itself out. The timing of payments matters less. But founders and CEOs can\u2019t wait that long to assess business performance. That\u2019s why the P&L exists. That\u2019s why profit metrics are essential. To read a P&L, you need to understand and appreciate the fundamentals of GAAP. Once you understand the limitations of cash flow and how GAAP solves those limitations, you\u2019ll be in a better position to run your company and make decisions. Revenue versus Sales. What\u2019s the Difference? As your business matures, so should your finance vernacular. Being precise with your finance language starts to matter once you\u2019re interacting with investors, lenders, auditors, and a board of directors. Revenue versus sales is a good example of how one small word can make a big difference.<\/p>\n\n\n\nEnter GAAP<\/strong><\/h3>\n\n\n\n
Profit and the P&L<\/strong><\/h3>\n\n\n\n
Profit or Cash Flow? You need both.<\/strong><\/h3>\n\n\n\n
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