Cash Flow vs Profit: Why Profitable Businesses Run Out of Cash

“We had our best year ever and nearly went under.” Accountants hear this surprisingly often. The business was profitable, but profit and cash are not the same thing, and the difference between them is where many businesses get into trouble. This guide explains the difference simply, shows the most common reasons profitable businesses run short, and how a cash flow forecast keeps you ahead of it.

The difference in one sentence

Profit is what you earn minus what it costs, recorded when the sale is made and the cost is incurred. Cash flow is money actually arriving in and leaving your bank account, recorded when it moves.

Over a long enough period the two tend to line up. Over a week, a month or a quarter, they can be very different, and bills are paid from cash, not profit.

A simple example

A design studio completes a $30,000 project in March. Its costs for the month are $22,000 in salaries, rent and software.

The studio made a healthy profit in March and its bank balance fell by $22,000. If it had $15,000 in the bank at the start of the month, it cannot pay its March costs, despite the profitable project.

Seven reasons profit and cash differ

1. Customers pay later than you invoice

Profit counts a sale when it is made or invoiced. Cash arrives when the customer pays, often 30 to 60 days later, sometimes more. The more you sell on credit, the bigger the gap.

2. Stock is paid for before it sells

A shop or online store may pay for stock two or three months before selling it. Profit only counts the cost of goods when they are sold; cash leaves when you pay the supplier.

3. Growth eats cash

Growth multiplies the first two problems. Every new customer means more staff, materials or stock paid for now and cash collected later. Fast-growing businesses are the most likely to run out of cash, precisely because they are winning.

4. Loans move cash but not profit

Borrowing brings cash in without any profit. Repaying the loan takes cash out, but only the interest is a cost in the profit and loss account. A business with large loan repayments can be profitable and still see cash fall every month.

5. Equipment and other assets

Buying a $40,000 van takes $40,000 of cash on the day. For profit, the cost is spread over the van’s life as depreciation, perhaps $8,000 a year. The profit and loss account barely notices; the bank account does.

6. Tax is paid later, in lumps

Sales tax or VAT, payroll taxes and income tax are often paid monthly, quarterly or annually. Some of that tax is money you collected for the government, so it was never your profit, but it still sits in your bank until it is paid, which can make the balance look healthier than it is.

7. Owner drawings and dividends

Money the owner takes out isn’t a business cost for profit purposes in many business structures, but it reduces cash just the same.

Signs you are confusing profit with cash

• Your accounts show a profit but you are regularly short at payroll time.
• You’re using the overdraft more each month even though sales are growing.
• A large quarterly tax bill surprises you.
• You feel comfortable after a strong month and are then caught out by the next quiet one.
• You decide to hire or buy equipment based on annual profit rather than the months ahead.

Worked example: growth that nearly broke a business

A wholesaler sells $100,000 a month at a 20 percent profit margin, and customers pay in 60 days. It wins a new contract that lifts sales to $150,000 a month from April.

The contract adds $30,000 of profit over the quarter. It also needs $80,000 of cash before the first payment arrives. Without a forecast and a funding plan, a very good contract becomes a very serious problem.

How to manage both

1. Keep a profit forecast or budget to decide whether the business, a product or a contract is worth doing.
2. Keep a cash flow forecast to decide whether you can afford it, and when. Our guide to how to make a cash flow forecast walks through it step by step.
3. Forecast growth in cash terms before you commit to it: extra staff, stock and materials in the month you pay, and extra receipts in the month customers really pay.
4. Separate tax money. Move sales tax and payroll tax into a separate account as you collect it.
5. Shorten the gap. Invoice promptly, ask for deposits, chase late payers, and negotiate longer supplier terms.
6. Arrange funding before you need it. An overdraft or invoice finance facility is easier to get while the business is profitable and calm.

How the gap shows up in different industries

The same principle plays out differently depending on how a business earns and spends:

• Construction: crews, subcontractors and materials are paid during the job, progress payments arrive 30 to 60 days later, and clients hold back retainage until completion. A profitable year can leave months of margin sitting with clients. See the construction guide.
• Ecommerce and retail: stock for the peak season is paid for months before it sells. Profit appears in November and December; the cash went out in August and September.
• Agencies and professional services: almost all costs are salaries paid monthly, while clients pay on 45 to 60 day terms.
• SaaS: annual prepayments bring cash in ahead of profit, the opposite pattern, which can make a business look richer than it is.
• Restaurants and cafés: cash arrives daily, so the gap is small, but thin margins mean a single slow fortnight or equipment failure can still cause a shortfall.
• Farms: inputs are paid in spring and income arrives at harvest, so profit for the year says little about cash in June.

Knowing which pattern your business follows tells you where to look first in your forecast.

Where profit and cash appear in your accounts

The profit and loss account (income statement) shows profit. The cash flow statement reconciles profit to the change in cash, adding back depreciation and adjusting for changes in money owed by customers, stock and money owed to suppliers. The balance sheet shows where the difference is sitting: in receivables, inventory, equipment and loan balances. A forward-looking cash flow forecast is what tells you what will happen next.

Start forecasting

If your business has complicated timing, such as construction retainage, restaurant food costs or ecommerce stock, an industry template starts with those lines built in. Browse templates by industry.