Most of us know what cash flow is and what profitability is. But as a small business owner, it’s important to truly understand the importance of cash flow as well as the subtle yet critical differences between cash flow and profitability.
For busy small business owners, it is critically important to understand the difference between your business revenue and profit. Both are important yardsticks for gauging how your business is performing. While they are closely related, they are also very different measures of the current state of play in your small business.
All small business owners know that their business needs to make a profit to be successful. But what roles do cash flow and profitability play in the context of succeeding as a small business owner? Let’s start by clearly defining each term.
What is cash flow?
Cash flow is the funds that your business is bringing in and spending. Another way to put it is that cash flow is the difference between the actual cash that your business receives, and the tangible cash used in the process of doing business. It’s essentially the flow of money into and out of your business. As such, cash flow is the lifeblood of your small business, which means cash flow management is one of the most important aspects of running a successful small business long-term.
When your cash flow is positive, your business has more funds coming in than it has going out – a clear sign that your small business is moving in the right direction and is financially healthy.
This is critical for small business owners, because without the right balance of cash going in and out of your business you may find it hard to pay expenses and accumulate a financial buffer to sustain your small business.
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What is profit?
On the other hand is profitability. Your profit is the revenue your small business generates from the sale of services or products, minus your business expenses.
Profit indicates whether or not a small business is generating revenue and income and whether a business is earning income, even if the cash hasn’t yet moved into or out of the business.
It’s important to note that a small business may incur non-cash expenses such as depreciation, which can reduce its profitability without actually affecting its cash flow. Conversely, investment in business assets, such as facilities and equipment, may also decrease the amount cash available to the business, but will not immediately impact on its profit.
Is cash flow or profitability more important?
So, is cash flow or profitability more business critical for your small business? To work out what is best for your business you should seek the advice of a professional, like an accountant, but the following will give you an idea of what to consider. Firstly, it depends on the current state of play in your business. If you have only just recently launched your small business, you may benefit from making cash flow your number one priority.
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However, if your small business is established, has a healthy list of clients, and has been growing steadily for a number of years, then your focus will rightly so skew towards profitability instead of cash flow.
Why cash flow is king
Ultimately, cash flow may well be more important when it comes to the long-term success of your small business. This is because without a healthy and sustainable cash flow, your business may struggle to pay its expenses and meet all of the financial obligations required of it.
It’s worth remembering that a profitable small business may still come undone due to cash flow issues. In fact, cash flow challenges may even bankrupt a small business in worst-case scenarios.
A small business can also have an enviable cash flow, but not be profitable. Such situations may be hard to sustain long-term. In the long-run, your business may be required to seek out investors to provide an injection of cash to make up for the losses in has incurred.
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To improve cash flow in your small business you may consider the following actions:
- Collecting your receivables faster.
- Increasing your sales frequency.
- Deferring tax payments where possible.
- Deferring creditors’ payments where possible.
- Selling and leasing back select fixed assets.
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