Cash flow and profit are two essential financial metrics. Understanding the difference between the two is important to effective decision-making for an organization.

What is cash flow?

Cash flow is the net balance of cash moving in and out of an organization over a period of time. For example, when a company purchases inventory or pays its employees, cash flows out; when a company makes a sale or an installment payment comes in, cash flows in.

A positive cash flow means there is more money coming in than going out in a given period; a negative cash flow means there is more money going out than coming in.

Types of cash flow

1. Operating: Often referred to as the “lifeblood” of the organization, operating cash flow is what is generated from an organization’s normal daily operations. To calculate operating cash flow, start with net income, add depreciation and amortization back in, and finally, make adjustments for non-cash assets and non-financial debts. If the operating cash flow is positive, then the organization’s daily operations are generating cash; a negative operating cash flow tells you the opposite is happening.
2. Investing: The cash flow generated from changes in fixed assets and short-term investments. The purchase of fixed assets (also known as capital expenditures) or short-term investment securities results in cash outflow; the liquidation of fixed assets would create an inflow.
3. Financing: The movement of cash between an organization and its investors, owners or creditors. Cash inflows include equity issuance and raising funds through debt financing (short-term and long-term). Cash outflows include the amortization of debt and distributions to shareholders.

Cash flow statement vs. income statement

A cash flow statement illustrates an organization’s ability to generate cash during a specific period of time. It breaks down the sources of cash and how the cash was used.

Also known as the profit and loss statement, the income statement shows an organization’s profits by summarizing the cumulative impact of revenue, gains, expenses and losses over a specific time period.

The income statement begins with revenue — the driver of an organization’s activities. Then it gets into expenses, progressing from the highest revenue-generating activity to the least. Product costs are shown before period costs because the former are incurred to create a new product with the intention of a sale, whereas period costs are not tied to production levels.

A cash flow statement differs from an income statement in goals and presentation. The cash flow statement shows actual money flows and gives a view into a company’s liquidity — that is, does it generate cash bills and make distributions to owners and shareholders? An income statement gives a view into a company’s profitability and, therefore, long-term solvency, or whether it will make money over the long run.

A key differentiator between the cash flow statement and income statement is accrual accounting. Revenue and expenses are noted in the reporting period in which they occurred as opposed to when the cash transaction took place.

For example, you may invoice a customer in April, but they may not pay you until June. Accrual accounting calls for the revenue to be accounted for in April when it was earned. Cash flow will recognize the payment in June. As this demonstrates, net income is usually not equivalent to cash flow.

Another key distinction is that income includes the impact of non-cash items that lower earnings, such as depreciation and amortization, which spread the impacts of large purposes over the useful life of an asset.

Direct method vs. indirect method

Cash flow statements are prepared using either the direct or indirect method.

The direct method starts by converting accrual accounts to a cash amount, which helps show actual cash usage. It reports cash inflow and outflow without getting into any adjustments needed to calculate accrued net income, and it examines business operations, calculating the total cash flow involved with each activity.

You can think of the direct method of cash flows as similar to tracking your daily expenses and income in your personal finances. Imagine you kept a detailed log of every dollar you earn and spend. On one side, you’d note your salary and any other sources of income. On the other side, you’d record every expense, like groceries, rent, utilities and entertainment.

Likewise, in a business context, the direct method of cash flows lists all cash transactions. It shows where the money is coming from and where it's going, giving you a clear and transparent view of the company’s financial situation. Similar to how your personal expense log helps you keep track of your spending and saving habits, the direct method helps you understand the company’s cash flow patterns and manage its finances more effectively.

The indirect method starts with net income, which is adjusted to include non-cash activities that occurred in the reporting period. Then, it records changes to balance sheet accounts. Both U.S. GAAP and IFRS allow organizations to use the indirect method; however, there are some differences regarding how the cash flow statement is prepared under each.

How do you choose when to use one over the other? The direct method is often used for short-term planning, i.e., under three months. As companies get bigger and planning becomes more complicated — with many parts to consider and a need to look further out in time — many move to the indirect method.

What is profit?

When all of an organization’s operating expenses are subtracted from its revenues, what’s left is the profit. An organization’s profit can be either positive or negative, and if it’s the latter, then it’s a loss.

A company has several options for what it can do with its profit. The first option is to reinvest into the business for growth. This could look like purchasing new equipment, funding projects or hiring more staff. Profit can also be used to manage the balance sheet, e.g., paying off debt. Profits can also be distributed to shareholders via dividends or share repurchases, or to employees via profit-sharing plans.

Types of profit

Gross profit is revenue minus the cost of goods sold (COGS). It shows how much money a company makes from its primary activities after the direct costs of production are subtracted. This type of profit indicates how much profit is left to cover indirect costs. If a company can’t achieve or sustain a positive gross profit, then its operations are financially unsustainable.

Operating profit, sometimes referred to as EBIT (earnings before interest and taxes), is the net profit an organization creates from its daily operations — the gross profit minus selling, general and administrative expenses, and depreciation and amortization expenses. EBIT is primarily used to determine a borrower’s ability to generate operating profits to meet its financial and tax obligations.

Net income, or “the bottom line,” shows income earned after all expenses have been deducted from all revenue, including tax and interest payments. It indicates the portion of earnings that can be distributed to shareholders in the form of dividends or share repurchases and is therefore used to calculate earnings per share.

Is cash flow or profit more important?

No one metric can tell you about the financial health of an organization. Understanding both profit and cash flow — and how they interact — is critical, as they tell you different things about an organization.

Cash flow gives you insight into a company’s liquidity, i.e., its ability to generate cash bills and make distributions to owners and shareholders, while profitability is concerned with whether a company will make money over the long run.

Sometimes cash flow and profit can even disagree. For example, an organization can have positive cash flow but fail to make a profit. Alternatively, an organization can be profitable but have a negative cash flow. To be financially healthy, both cash flow and profit need to be positive.

---