If you are a business owner, accounting terms may appear interchangeable to you — and many of them may seem like speaking a foreign language. As much as you may want to concentrate on the details that mean the most within your industry and market segment, understanding the nuances of the different words used in financial reports can make a real difference in your understanding of your business’ health, and even give you valuable insights to help drive decisions.
To start you on the road to greater accounting fluency, let’s start with the terms “profit” and “cash flow.” We’ll look at what they mean, how they are used, and what they mean for gauging your business success.
Two terms that essentially mean the same thing but are used differently – profits and net income – both distinguish the difference between the money that your business takes in and what it is spending in order to operate. You will generally see the term “profits” on an accounting statement called a profit and loss (P&L) statement or an income statement. It tracks the money coming in and going out over a limited period such as a quarter or a year. If a business’ income over the course of a year is $100,000 and its expenses are $70,000, then its net profit is $30,000 – determining the number is simple subtraction.
Similarly, net income totals all the income that a business takes in – known as gross income – and then subtracts expenses. The information is generally recorded on a tax return, with sole proprietors recording both on Schedule C of their 1040/1040-SR tax return, calculating the net income and then adding it to the rest of their income and deduction information for submission to the Internal Revenue Service.
Your business’ cash flow is reflected by the amount of cash available in your business checking account, as well as other accounts including money markets, savings, or anywhere else where cash is readily available. Cash is viewed as an asset in the same way that equipment or property is. The difference is that you can use this asset to pay your bills and expenses immediately.
In addition to the cash you can access instantly, other business assets are considered when calculating cash flow. These are instruments that you can convert to cash in a relatively short period of time such as the amount that your customers owe you (also known as accounts receivable), stocks and bonds, and inventory. When an accountant refers to cash flow, it is generally in terms of whether it is positive or negative, with positive meaning that you have more money moving into your business than out, and negative meaning that you have more cash going out than coming in. The latter is indicative of a problem – you’re spending more than you have coming in from your customers, and you’re likely to run into problems paying your bills unless you have a way of adding more cash in to your checking account.
Tracking your cash flow in a cash flow statement is a useful way of monitoring the ebb and flow of your income and expenses, as well as for reporting it to stakeholders. Most cash flow statements are issued on an annual, calendar-year basis and reflect how much cash on hand (and cash equivalents) you started the year with and ended the year with.
Cash flow and changes in cash and cash equivalents over the course of the year reflect a variety of activities. In addition to income and expenses, it also reflects moneys that come in or out from expenses or financing, as well as depreciation and amortization on major assets and changes in the value of other assets.
Now that you have a basic understanding of what the terms “profit” and “cash flow” mean, you need to understand how they apply to a typical business. Let’s say that at the end of a quarter your profit is $5,200 but your business bank account holds just $3,000 received as payments from customers over the last few months. If you owe the electric company $220, your landlord $1,100 and your freelance web designer $850, then after paying those creditors you will have just $830 left in your account. Even though your profits for the quarter were more than six times that amount, you can only pay yourself as the business owner $830. It’s a reflection of your cash flow.
Another way to understand cash flow is as liquidity. This refers to how much money you can access either to invest or to spend, and it is different from profitability, which not only reflects income minus expenses, but is also differentiated by the fact that those expenses might not be expressed in outgoing cash.
Here are some of the other types of expenses that businesses consider when calculating cash flow and profitability:
For more information on how profit and cash flow are impacted by different types of business transactions, check out the detailed analysis assembled by Iowa State University's Business Extension and Development Department.
Cash and accrual are the two types of accounting methods available to businesses as they prepare their financial reports. The first records expenses in the year the money was spent and income in the year that payment was received. Accrual accounting reports income based on when the business issues an invoice rather than when it is paid and recognizes expenses at the time that a bill is received rather than when it is paid. This has a profound impact on the way that cash flow and profits will look, especially at the end or beginning of the year when an invoice may have been issued but not yet paid or received and not yet paid. A late-December sale of $3,100 will generate an invoice that shows in one year but will not be paid until January of the following year at the earliest. Using accrual accounting that would mean that the $3,100 would show up as income in the previous year, even though the business has not received the cash to pay for it. Similarly, if your business receives a bill in late-December in the amount of $8,000 but doesn’t pay it until January, the expense will be recorded in a different year from when the money leaves your bank, leaving a larger amount reflected in your cash flow statement.
While both cash flow and profit are important to businesses, they each have a different function, and neither one is more important than the other. It’s also important to remember that sales and expense numbers can be reported in a way that show both a profit and a negative cash flow, or a positive cash flow and no profit.
The importance of each of these numbers will often depend on the business’ specific situation. Businesses that are just starting out or that rely heavily on cash in order to pay their bills quickly will emphasize cash flow: for them, having enough cash on hand to allow them to pay their bills will make all the difference in their business’ viability. Though cash flow is important for every business throughout their history, being able to show that your business makes a profit makes it more likely that you will be able to attract investors, borrow money, and keep your business successfully operating for a very long time.
About Frank Jenkins Jr
Frank Jenkins Jr. CPA is the managing partner of Adams, Jenkins & Cheatham, a CPA practice based in Midlothian, VA. Frank specializes in Consulting services, tax planning, audit & assurances. "I genuinely care about our clients because I have a personal connection with them." He is active in the community and belongs to the AICPA and the VSCPA.
