[ad_1]
:max_bytes(150000):strip_icc():format(jpeg)/GettyImages-490024232-ce77fc165c6147d2a4a6fa1c28824297.jpg)
Cash flow and profits are two very important metrics that can define the success of a business. This makes them very crucial for the financial health and well-being of a company. Which is more important depends on the context. For a business to be successful, it needs to generate positive cash flow and profits. In this article, we study cash flow and profits and determine the importance of each.
Key Takeaways
- Cash flow and profits are two key metrics to measure a company’s success.
- Companies need to generate positive cash flow and profits to be successful.
- Positive cash flow is important in the short term because it means a company can meet its financial obligations.
- Profits are important as a long-term measure of success because a company can expand and reinvest that money in its growth.
What Is Cash Flow?
Cash flow is the flow of money into and out of a business. Cash flow is necessary for daily operations, taxes, purchasing inventory, and paying employees and operating costs. A company can generate cash flow from its operations, investment activity, and financing:
- Operations: This is money directly related to the production and sale of goods and services.
- Investing activity: This is money related to any investment activities the company engages in, such as the investment in securities or assets.
- Financing: This includes any money related to dividend payments and the issuance of debt like corporate bonds.
Cash flow can be positive or negative:
- Positive cash flow indicates that there is more money coming in than going out or that a company’s liquid assets are increasing. This enables it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges.
- Negative cash flow indicates that a company’s liquid assets are decreasing. This means that there is more money going out than coming in.
One thing to keep in mind is that negative cash flow isn’t always a bad thing. New companies may have negative cash flow and it is common for some companies to have more outflows if they’re investing in their growth.
Important
Long-term negative cash flow may indicate a problem, including a drop in sales, overspending and/or the inability to pay off debts. Companies should develop a plan to address the issue(s).
What Is Profit?
Profit is the surplus after all expenses are deducted from revenue. It is the overall picture of a business and the basis on which tax is calculated.
There are three major types of profit that analysts analyze:
- Gross profit: This is the amount of money left after subtracting the cost of goods sold (COGS). This type of profit indicates how well a company manages its production costs.
- Operating profit: This form of profit is derived from a company’s core operations and excludes the deduction of interest and taxes.
- Net profit: Also called net income, this is the amount of money a company earns after accounting for all costs and expenses.
Each type of profit gives analysts and investors more information about the company’s performance, especially when compared against other periods and industry competitors. All three levels of profitability can be found on the income statement.
Which One Is More Important to a Business?
Determining whether cash flow or profit is more important depends on the business and the circumstances. In most cases, cash flow is important in the short term while profit is key for a company’s long-term success.
For example, a business may see a profit every month, but its money may be tied up in hard assets or accounts receivable (AR) with no cash to pay employees. Once a debt is paid or the business sees an influx in revenue, it starts to see positive cash flow again. Cash flow is more important in this case because it keeps the business running while still maintaining a profit. Alternatively, a business may see increased revenue and cash flow, but there is a substantial amount of debt, so the business does not make a profit.
Profit, on the other hand, is important when there is its absence has a declining effect on a company’s cash flow. Another thing to remember when determining whether to focus on cash flow or profit is cash flow can be bought. A business owner can put up their personal assets as capital into the business. Or, they can get a small business loan from a bank to keep the business running until it starts seeing cash flow again.
How Do You Calculate Cash Flow?
One of the simplest ways to calculate cash flow is to add up a company’s current assets and subtract that figure from that total current liabilities. You can find the current assets and current liabilities on a company’s balance sheet.
Is Revenue the Same as Profit?
No, revenue and profit aren’t the same thing. Revenue is the total amount of money that a company earns from the sale of its goods and services. Profit, on the other hand, is the money that is left over after the company pays its expenses and costs, including invoices, debts, and interest payments.
What Is a Cash Flow Statement?
A cash flow statement is one of the key financial statements required by public companies. This document tracks money that flows in and out of the company and provides insight into its financial health—notably, whether it is able to sustain its operations, invest its money, and pay off its financial obligations.
The Bottom Line
There are different metrics you can use to determine the success of a company. Cash flow and profits are two of those factors. Both are equally important but in different situations. Cash flow is important in the short term because it can affect how a company can meet its financial obligations. Profits are critical for long-term success because they allow companies to expand and continue to operate.
[ad_2]
Source link