Many non-finance professionals think that a business earning a profit means its cash balance went up by the same amount. If you are one of them, then we suggest you read this article in which we have explained why a company’s net profit and cash flow are two different bottom lines.
A company can have higher profits while having a poor cash flow.
A healthy cash flow does not necessarily indicate good profit. Therefore, you must know the difference between net profit and cash flow.
Before getting into the difference, let us understand what is cash flow and what is net profit.
What is net profit?
Net profit is taken from the income statement of a company.
Income statement summarizes the revenue and expenses of a business for a period of time.
Net profit is the amount of money a company makes after subtracting all expenses, taxes, and cost from total revenue. Its final profit remains after accounting for everything that impacts the bottom line.
Here is the simple formula presented in a profit and loss account to calculate net profit:
Net profit = Total Revenue – Total Expenses
Total expenses includes cost of goods sold, operating expenses, depreciation and all other costs associated with running the business.
Net profit is often referred to as “Net Income”, profit after tax (PAT) or “Net earnings”.
What is cash flow?
Cash flow means the money that flows into, through and out of the business during a period. Cash flow is calculated to measure how well a company manages its cash position to ensure it has enough liquidity to cover expenses and investments.
In a cash flow statement you will find three main type of cash flows;
Operating cash flow
This is the cash generated or used by a company’s core business operations, which includes cash receipts from sales of goods and services, and cash payments for operating expenses like salaries, rent, and utilities.
Investing Cash Flow
Investing cash flow refers to cash transactions related to the acquisition or sale of physical assets, investments, and securities. Investing cash flow includes purchases of property, equipment, or investments, as well as cash received from selling these assets.
Financing Cash Flow
Cash transactions related to raising capital and paying back loans are shown as financing cash flow. It includes cash received from issuing stock or borrowing, as well as cash paid out in dividends or loan repayments.
A positive cash flow indicates that the company is generating more cash than its spending.
Negative cash flow suggests the company is spending more than it’s bringing in.
How is net profit and cash flow different?
A company’s net profit and cash flow differ due to accounting principles followed. Both are required as they measure different aspects of financial performance.
Net profit in a profit and loss account is calculated based on accrual accounting, which recognizes income and expenses as they are earned or incurred. This means, it’s not recognized as and when cash is received.
This means, while calculating net profit, we consider non-cash items such as depreciation and amortization.
However, in the cash flow statement we take only cash transactions. Cash flow statement focuses solely on actual cash transactions. It considered cash that is coming in and going out of the business.
In the income statement or profit and loss account, we consider revenue and expenses when they are earned or incurred, regardless of when cash is actually received or paid.
Cash flow only considers actual cash inflows and outflows.
If revenue earned but not received in cash, then it’s not considered in the cash flow statement. Similarly if expenses are incurred but not paid, that means there is no cash out flow, therefore not considered in the cash flow statement.
Example
A company records revenue from sale when the sale is made, even if cash is not received until later.
Which means both cash and credit sales are reflected in total revenue.
In a cash flow statement, if a company has made a sale on credit, it will not show up. Only sales for which cash is received will reflect in the cash flow statement.
A company might show you net profit of Rs 10,00,000 for a financial year. However if the company made significant sales on credit and has not received cash by the end of the financial year, its actual cash flow might be negative.
Similarly, if a company has invested in new equipment and loan repayments, then these transactions will be reflected in cash flow statements not in income statements impacting net profit.
Which one should we consider: net profit or cash flow?
Both are important in order to assess a company’s financial health.
Net profit shows actual profitability and helps to assess financial performance. Cash flow statement shows liquidity and the company’s ability to sustain in business and invest in growth.
Cash flow is considered as the lifeblood of a company which helps the business to run its day to day business, the net profit is the ultimate goal of the company and investors.
In addition to cash flow and net profit, by analyzing different financial metrics such as Price-to-Earnings (P/E) Ratio, comparison of earnings before interest and taxes (EBIT) and operating cash flow, Return on Invested Capital (ROIC), Working capital requirements, Net Profit Margin, Operating profit, Free Cash Flow (FCF), and other Financial ratios, an investor can get better understanding of how efficiently a company turns its net profit into cash, how well it manages its investments, and how sustainable its financial performance is.
