Cash flow and profit are two important financial metrics in small business accounting. Getting a grapple on their roles and differences between the two is an important aspect of setting yourself up for financial success. To help you as a small business owner understand the ins and outs of cash flow management, the team at Shoebox have broken down both concepts for you!
To learn more about common tax mistakes small business owners make, we’ve covered the top six mistakes and how you can avoid them.
What is a gross profit?
Gross profit is defined as the revenue remaining when all expenses for manufacturing and selling a product or service have been subtracted.
The gross profit helps you as a business owner understand how much money you need to make to generate revenue. It’s an important figure that tells you if your business is profitable. Once earned, a business’ gross profits can be distributed in a variety of ways. Either to the owners, shareholders – usually in the form of dividends payments, or reinvested back into the company to assist future growth. This can be done by purchasing more stock, increasing marketing budgets, or using research or product development.
How to Calculate Gross Profit:
Total Revenue – Cost of Goods Sold = Gross Profit
Your gross profit is calculated by subtracting the cost of goods sold (COGS) from the total revenue. Let’s say that your total revenue for a given week is $5.000, but it costs you $3.000 to make and sell your product or service to generate that revenue. In that case, your gross profit margin for that week is $2.000. This number does not include any tax or business operating cost, such as rent, payroll or loan payments – that’s why we also have to look at net profit.
It’s important to note that gross profit can be depicted as a positive or negative number. When profits are in a negative number, it’s referred to as a loss, because your business has spent more money operating than it was able to recoup from its operations.
What is Net Profit?
|Net Profit is the revenue that remains when all expenses for manufacturing and selling a product or service and all business operating costs, including tax, payroll, rent loan payments and insurance, have been subtracted.|
Net profit factors in liabilities beyond the cost of goods sold and therefore better reflect your businesses’ profitability. This is because it includes expenses such as your employees’ payroll, office rent, loan payments and any other expense not directly linked to the production of your business offering.
How to Calculate Net Profit:
Gross Profit – Total Expenses = Net Profit
Net profit is calculated by subtracting COGS, all business operating expenses, interest and taxes from your total revenue. Net profit is often referred to as the ‘bottom line’ of a business and may also be called ‘net earnings’ or ‘net income’.
|Example Income Statement|
|Cost of goods sold||$50.000|
|Total operating expenses||$105.000|
What is Cash Flow?
|Cash Flow is the amount of money that flows in and out of a business at any given time.|
The term cash flow refers to the movement of money in and out of a business. Any money that comes into the business is defined as inflow, whilst money that is spent represents outflow. Why does this matter? Cash flow is used to determine your business’s short-term and long-term outlook.
|Positive Cash Flow||Negative Cash Flow|
|Cash flow positive is when you have more money moving into the business than you have moving out at any given time.||Negative cash flow is the opposite — the amount of money you have going out of the business is greater than the amount of money you have coming in.|
Note that our definition of cash flow includes the keywords “at any given time”. Cash flow has to be analysed through the lens of a given timeframe. You may, for example, choose to do this on a monthly or quarterly basis.
What is a Net Profit Margin?
In order to understand your businesses profitability, you can also use a method that uses profitability ratios such as the “net profit margin”. Net profit margin looks at the ratio of net income and outgoing cash flow to revenue and is expressed as a percentage.
Net Profit Margin Calculation:
(Total Revenue – Cost) : Total Revenue = Net Profit Margin
The net profit margin is calculated by subtracting the cost of goods sold (COGS), operating expenses, other expenses, interest on debt, and taxes payable from the total revenue and then dividing the result by revenue. To convert the figure to a percentage, multiply it by 100.
Cash Flow vs. Profit: What’s The Difference?
Both your net profit and cash flow are important margins for business success. The difference being that profit indicates the amount of money left over once all expenses have been subtracted, whilst cash flow indicates the movement of money into and out of your business.
Which is more critical for small businesses: cash flow or profit?
A question many small new small businesses are interested in that is the most important is: What should you look at? Cash flow or profit?
- Net profit is better at indicating the success of a business as it looks at financial gains or losses over an extended period.
- Cash flow is important in keeping a business’ doors open.
But in the long run, a lack of profit will negatively impact cash flow because your business will have a hard time remaining cash flow positive for long. In other words, your net profit may be more indicative of your business’s long-term success, whilst cash flow can indicate how well the business is maintaining profits on a day-to-day basis. Profits won’t save your business if they are not continuous and spent wisely.
The Bottom Line
Net profit is the revenue remaining after deducting all costs associated with operating your business and producing and selling your goods or services, whilst cash flow is the amount of money flowing in and out of the business at any given time. Time is the main difference between cash flow and profit. Cash flow only shows you a snapshot in time and can’t show you the whole picture of how your business is performing financially.
If you find yourself wanting assistance with your business finance management to better understand your business’s profits and cash flows, contact Shoebox Books and Tax today and have your business finances managed by highly experienced accountants!