Cash Flow vs Profit – What’s the difference?
It seems strange, but the easiest way to explain the difference between cash flow vs profit is to look at the balance sheets of a business. The movements between balance sheets is the key to understanding cash flow vs profit.
The table below shows the opening and closing balance sheets of a typical business, and in the final column shows the movement between the two balance sheets. The presentation has been simplified for the purpose of this explanation.
Beginning and Ending Balance Sheets
| Balance sheet | Beginning | Ending | Movement |
|---|---|---|---|
| Fixed Assets | 20,000 | 55,000 | 35,000 |
| Cash | 3,000 | 7,500 | 4,500 |
| Accounts receivable | 5,000 | 9,000 | 4,000 |
| Inventory | 4,500 | 8,000 | 3,500 |
| Accounts payable | -6,000 | -8,500 | -2,500 |
| Loans | -12,000 | -45,000 | -33,000 |
| Net assets | 14,500 | 26,000 | 11,500 |
| Capital | 10,000 | 15,000 | 5,000 |
| Retained earnings | 4,500 | 11,000 | 6,500 |
| Equity | 14,500 | 26,000 | 11,500 |
The Balance Sheet Movements
If we look at the movement column, we can group together accounts receivable, inventory, and accounts payable, as these combined are called the working capital of the business.
| Balance sheet | Movement | Explanation |
|---|---|---|
| Fixed Assets | 35,000 | Fixed asset movement |
| Cash | 4,500 | Cash Flow |
| Working capital | 5,000 | Working capital movement |
| Loans | -33,000 | Loan movement |
| Net assets | 11,500 | |
| Capital | 5,000 | New equity capital injected |
| Retained earnings | 6,500 | Profit for the year |
| Equity | 11,500 |
Balance Sheet Movements Rearranged
If we simply rearrange the movements while maintaining the balance on both sides, we get the following.
| Balance sheet | Movement | Explanation |
|---|---|---|
| Cash | 4,500 | Cash Flow |
| 4,500 | ||
| Retained earnings | 6,500 | Profit for the year |
| Working capital | -5,000 | Working capital movement |
| Fixed Assets | -35,000 | Fixed asset movement |
| Loans | 33,000 | Loan movement |
| Capital | 5,000 | New equity capital injected |
| 4,500 |
As both sides are equal (in this case 4,500) we can see that
Since we know the following:
- Fixed asset movement = Capital expenditure – Depreciation
- Loan movement = New loans + Interest – Loan repayments
We can rearrange the formula to give the following cash flow formula:
We now have a formula showing cash flow vs profit and we can see that:
- Cash flow and profit are not the same
- Profit is only one small element of cash flow.
- A business can be profitable but still have a negative cash flow
- If the profit margin is small, it is more important to control working capital (inventory, account receivables, and account payables)
- Capital expenditure needs to be matched by new loans (or new equity) to avoid affecting cash flow.
- As a business grows its working capital funding also grows (inventory and account receivables get higher), and cash flow can rapidly decline unless alternative sources of funding for expansion are found.
- It is important to understand the balance sheet and balance sheet movements to understand and control cash flow.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.