This week I wanted to talk about the difference between cash flow and profit. This is a very important distinction that creates a lot of confusion, so I will be breaking it down for you in this video. WATCH NOW
So many times, I hear people talk about companies and stocks and they talk a lot about profit. When I hear this, it makes me cringe a little bit, because so many times profit can be misleading. What you want to do is look at both profit and cash flow. The two terms together create a much better picture of what is going on in a company.
I want to start from the big picture. One of the primary jobs of an accountant is to enable capital markets. In capital markets we have businesses and investors. Investors are rich people with a lot of money they want to be able to put to work to generate a rate of return. But investors have a problem. They do not know what is happening inside a business. Accountants provide investors a set of financial statements to provide them insight. So accountants are enabling this cycle where investors are giving money to businesses that then pay out dividends back to investors.
The takeaway here is financial statements are written for investors. The whole reason the income statement highlights profit, is because that is what investors care about. They want profit, because profit will become dividends that flow back to investors. The investors are looking at these documents and thinking “what is in it for me.”
It is important for business leaders to realize the purpose of financial statements because the focus on profit can be misleading. It is easy to bury things in an income statement if you do not know what you are looking for. For example, depreciation is a huge expense on the income statement, but it does not actually impact the amount of cash you have in the bank.
One way accountants correct for this, is by creating the Statement of Cash Flows. This statement shows where the cash is going in the business. It contains three different sections:
- Operating – shows whether the core business making or losing cash
- Investing – includes buying or selling investments like land
- Financing – includes activities like issuing debt or paying out dividends
The area you want to focus on is operating. Is the operations generating cash or losing cash? A business should be a cash flow machine, and so you should see cash being generated.
The point of all of this discussion is to highlight the difference between profit on the income statement and cash flow from operations on the Statement of Cash Flows. It is really important that you look at both of these numbers and understand what they mean.
A lot can be hid in profit. Just because a business shows a loss, is not necessarily a bad thing. A business could generate a lot of money, but simply invest all those funds back into the business. So the income statement will show a loss, but it could actually be a healthy, growing business. The operating cash flow will be much more straight forward, because it will show if the business is generating cash. Of course, the business could be making sales where the cash has not arrived yet, but that is a situation where you would want to investigate to find out why people have not been paying.
Now it is still possible to hide things within the operating cash flow, so next week I will show you how to break down the statement of cash flow even further, and this can be a very powerful way to understand what is going on in your business.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.