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Cash Flows as Profit and Components of Cash Flows

Cash flow and profit are two different financial parameters, but when you’re running a business, you need to keep track of both. Here’s how they’re different, why they’re both important and how they intersect with other corporate issues, especially when a company grows rapidly.

Cash Flow

Cash flow is the money that flows in and out of the firm from operations and financing and investing activities. It’s the money you need to meet current and near-term obligations. But there are two things to keep in mind about cash flow:

A Business Can Be Profitable and Still Not Have Adequate Cash Flow

In the worst case, insufficient cash flow in a profitable business can send it into bankruptcy. For example, you’re making widgets and selling them at a profit. But your product goes through a long sales chain and some of your biggest and most important wholesale customers don’t pay on invoices for 120 days. This sounds extreme, but many large US corporations in the 21st century don’t pay an account payable for three or four months from the receipt of the invoice.

Since you’re the little guy, the suppliers of materials you need to make those widgets often want to be paid either upon receipt or in 15 or 30 days. Ironically, if you’re caught between suppliers who want their money now and buyers who’re slow to pay, a successful product with increasing sales can create a real cashflow crisis. Even though your unit sales are increasing and profitable, you won’t get paid in time to pay your suppliers and meet payroll and other operational expenses. If you’re unable to meet your financial obligations in a timely way, your creditors may force you into bankruptcy at a period when sales are growing rapidly.

Your Sales May Be Growing and the Money Keeps Pouring In, but That Doesn’t Mean You’re Making a Profit

If you borrow money to solve the cash flow problem, for instance, the rising debt costs that result can raise your costs above the breakeven point. If so, eventually your cash flow will dry up and eventually your business will fail.

Profit

Profit, also called net income, is what remains from sales revenue after all the firm’s expenses are subtracted. It’s obvious in principle that a business cannot long survive unless it is profitable, but sometimes, as with cash flow, the very success of a product can raise expenses. It may not be immediately apparent that this is a problem. In other cases, you may be aware of the problem, but believe that by reducing production costs you can restore profitability in time to avoid a crisis. Unfortunately, unless you have a clear understanding of all the relevant cost data, you may not act effectively or promptly enough to make the firm profitable again before it runs out of money.

Components of Cash Flows

(i) Cash Flow from Operating Activities

The net amount of cash coming in or leaving from the day to day business operations of an entity is called Cash Flow from Operations. Basically it is the operating income plus non-cash items such as depreciation added. Since accounting profits are reduced by non-cash items (i.e. depreciation and amortization) they must be added back to accounting profits to calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst about the viability of an entities current business plan and operations. In the long run, cash flow from operations must be cash inflows in order for an entity to be solvent and provide for the normal outflows from investing and finance activities.

(ii) Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets such as land, buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities, etc. Most cash flow investing activities are cash out flows because most entities make long term investments for operations and future growth.

(iii) Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to bondholders) and shareholders (i.e. dividends and stock buybacks) and cash inflows from sales of bonds or issuance of stock equity. Most cash flow finance activities are cash outflows since most entities only issue bonds and stocks occasionally.

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