Cash Flow vs Profitability: Key Difference
In strategic financial management, cash flow and profitability are two pivotal concepts that often get confused. Though, they serve different purposes, both are mutually dependent, but must be managed judiciously to achieve a company’s long-term success. Understanding their clear distinctions and interdependence can help companies, investors, or business owners make informed financial decisions and ensure sustainability.
What is Profitability?
Profitability measures the ability of a company to generate profit after deducting all cash outflows(expenses) from revenue. It is represented in three (3) forms, including:
- Gross Profit: Revenue minus the cost of goods sold (COGS)
- Operating Profit: Gross profit minus operating expenses (OPEX)
- Net Profit: The final profit available for distribution after deducting all expenses, including taxes and interest.
Profitability is a key indicator of a company’s financial performance and long-term viability. However, it does not show that a company is liquid to meet short-term financial obligations when they become payable.
What is Cash Flow?
Cash flow refers to the actual receipts and payments generated by a business in a period. It represents the movement of money into and out of a business. For instance, when a company sold goods to customers, cash flows into the business and when the company pays staff salaries, cash flows out of the business. It is usually grouped into:
- Operating Cash Flow: Cash generated from ordinary activities of the business.
- Investing Cash Flow: Cash paid to acquire non-current assets or received from disposal of assets.
- Financing Cash Flow: Cash related to borrowing, debt repayment, or dividend payments.
A company can be profitable in theory but still experience cash flow problems if cash is tied up in receivables or inventory.
Key Differences Between Cash Flow and Profitability
Why Both Matter for Business Success
A Profitable Business Can Liquidate Due to Cash Flow Problems
Many profitable companies collapsed due to lack of working capital to cover business operating expenses such as salaries, rent, payment to suppliers, or settlement of short-term debt obligations. Hence, poor cash flow management can lead to insolvency.
Strong Cash Flow Position Enables Growth and Flexibility
A strong cash flow position will enable a company to invest surplus funds in short-term marketable securities, expand, reinvest in operations, and undertake new opportunities, even though the business is not highly profitable yet.
Financial Metrics for Investors and Lenders
While investors look at profitability to measure a company’s long-term potential, lenders assess cash flow to determine the business’s ability to settle debt obligations.
Strategic Decision-Making Requires Balance
Maintaining balance between profitability and cash flow is essential to achieving a business success. A company that focuses only on profitability and neglect cash flow, may experience liquidity problems. On the flip side, prioritizing cash flow without ensuring profitability can deny the business the opportunity to attract the right investments.
How to Manage Cash Flow and Profitability Effectively
- Monitor Cash Flow Regularly: Ensure accurate forecasting and use cash flow statements to anticipate shortages.
- Optimize Receivables and Payables: Encourage early settlement discount from customers and negotiate better payment terms with suppliers.
- Cost Optimization: Identify and manage costs efficiently. Avoid unnecessary expenses.
- Balance Growth and Liquidity: Invest strategically without compromising cash reserves.
- Leverage Technology: Integrate accounting software to automate financial processes, track cash flow, and generate reports.
- Inventory Management: Optimize inventory levels to avoid over/under stocking of materials, avoid stock-out and wastage, and improve efficiency. You can also adopt just-in-time system (JIT) so that you request for inventory only when it is needed.
- Marketable Securities: Invest surplus funds in short-term marketable securities like treasury bill, commercial papers, bankers acceptance, etc.
In Summary
Both cash flow and profitability are essential for business survival and success. A company needs profits to sustain operations in the long run but also requires healthy cash flow to keep running smoothly. Striking the right balance between the two financial metrics ensures stability, growth, and resilience in an ever-changing business environment.
At Greena, we pride ourselves with highly experienced and committed professionals willing and ready to collaborate with businesses to create value
SIGN UP below to receive compelling articles to improve your business
One Response