Running a business in Singapore is no small feat. With a myriad of responsibilities fighting for our attention, it’s easy to get lost in the day-to-day operations and overlook critical financial concepts. Many of us do not exactly know the concept of cash flow vs profit. While they might sound similar, they play very different roles in telling us about our business’s financial health. Understanding the difference between cash flow and profit is crucial for making informed decisions that drive your business forward.
What is Profit?
Profit is the financial gain your business makes after deducting all expenses from total revenue. It’s typically divided into three categories:
- Gross Profit: This is your total revenue minus the cost of goods sold (COGS). It indicates how efficiently you’re producing and selling your products. If you are in the service industry, your COGS includes the cost of your manpower who works directly with clients. For example, accountants who provide accountancy services to SME clients are considered COGS for an accountancy firm.
- Operating Profit: Also known as operating income, this is your gross profit minus operating expenses (like rent, utilities, and salaries). It shows the profitability of your core business operations. In the same accountancy firm example, the cost of your marketing staff will fall under operating expenses.
- Net Profit: This is what’s left after all expenses, including taxes and interest, are deducted from your total revenue. It’s often referred to as the bottom line and indicates the overall profitability of your business.
What is Cash Flow?
Cash flow refers to the net amount of cash moving in and out of your business. It’s divided into three main categories:
- Operating Cash Flow: Cash generated from your core business activities, like sales of goods or services.
- Investing Cash Flow: Cash spent on or received from investments, such as purchasing equipment or selling a piece of property.
- Financing Cash Flow: Cash exchanged between your business and its owners or creditors, including issuing shares, borrowing money, and repaying loans.
Positive cash flow means more cash is coming into your business than going out, which is crucial for covering expenses, investing in growth, and weathering financial challenges especially during an economic downturn.
Understand the Difference between Cash Flow and Profit
Understanding the difference between cash flow and profit can help you make better financial decisions. Here are some key differences:
- Timing: Profit is recorded when transactions occur, regardless of when cash is actually exchanged. Cash flow, on the other hand, only considers the movement of actual cash. For example, if you distribute dried goods to restaurants with 30 days credit, your profit is recorded when the goods is delivered but cash is only recorded when the client makes payment.
- Measurement: Profit is an accounting concept calculated according to specific rules and includes non-cash items like depreciation. Cash flow is a measure of real cash movement, providing a more accurate picture of liquidity.
- Scope: Profit focuses on earnings over a specific period, while cash flow provides insight into the business’s ability to generate cash over time, highlighting its financial health and operational efficiency.
To summarise the key differences between cash flow and profit, take a look at this example:
Your business booked $500,000 of sales this month but all your customers are given a 90-day credit terms. Assume COGS, operational expenses and all other costs are both 0, your profit for the month is $500,000. Yet, your cash flow for that month is $0 because you have yet to collect your payment. Without the cash in your bank, you are unable to use this “profit” to pay for marketing or anything else as a matter of fact. This is why cash flow is a better indicator of a company’s liquidity – your ability to pay for expenses.
Why Cash Flow is More Important for SMEs
While profit is essential, cash flow is often more critical for the day-to-day survival of an SME:
- Liquidity: Positive cash flow ensures you have enough liquidity to cover short-term obligations like salaries, rent, and supplier payments.
- Flexibility: With a healthy cash flow, you can take advantage of growth opportunities, such as investing in new technology, hire more people or expanding your product line.
- Resilience: Cash flow helps you tide through economic downturns, unexpected expenses, and other financial shocks without resorting to high-interest loans or other desperate measures. Many business owners utilize their personal credit cards in such times and when they struggle to pay the full sum back when the statement is due, banks charge
Common Cash Flow Mistakes SMEs Make
- Ignoring Cash Flow Statements: Many business owners focus solely on profit and loss statements, neglecting the cash flow statement, which can provide vital insights into the business’s liquidity.
- Overestimating Sales: Assuming that all sales will convert to immediate cash can lead to cash flow issues, especially if clients delay payments. This is especially common in B2B businesses where credit terms are given and there’s nobody within the company to chase for timely payments.
- Underestimating Expenses: Failing to account for all expenses, particularly one-time or irregular costs, can create unexpected cash flow shortfalls.
- Poor Inventory Management: Overstocking ties up cash that could be used elsewhere, while understocking can lead to lost sales opportunities.
Cash Flow Hacks and Tips
To help you better manage your cash flow, here are some hacks and tips that many SME owners aren’t aware of:
- Invoice Promptly and Follow Up: Send invoices as soon as goods are delivered or services are rendered. Use automated reminders to follow up on overdue invoices to ensure timely payments. Have this as a KPI of one of your colleagues. If you are in the B2B space, consider only paying out commissions to salespeople after payment is received from the client. This usually incentivizes salespeople to help chase for payment. If more than one person is accountable, nobody is accountable.
- Negotiate Payment Terms: Work with suppliers to extend payment terms even if it’s an extension of a couple of days. This allows you more time to pay without affecting your cash flow. In business, you get what you negotiate. Alternatively, try to negotiate shorter payment terms with your clients, especially after you have established yourself as a reputable vendor. Our rule of thumb: COLLECT FAST PAY SLOW.
- Implement a Cash Reserve: Set aside a portion of your profits into a cash reserve fund. This can act as a buffer during periods of low cash flow or unexpected expenses. It is recommended to keep about 3-6 months of expenses but it can vary for different industries. If you are a fashion business that produces your own line, you may need to standby extra funds for ongoing procurement.
- Use Technology: Invest in cash flow management software that provides real-time insights and forecasts, helping you make informed decisions and plan for the future. If you are looking for a free option, Wave is a good place to start. If you are looking to have an accountant manage your finances for you, you may want to consider Xero. What I like about Xero is that it allows me to sync my bank feeds of all my business accounts automatically for easy reconciliation.
- Optimize Inventory Levels: Use just-in-time inventory management to know the exact amount of inventory needed so as to minimize excess stock and free up cash. Excess inventory not just locks up cash but also takes up warehouse space. Regular reviews of your inventory ensure it aligns with current demand. We strongly recommend seasonal businesses to study inventory usage to set aside additional resources (not just cash) to meet peak season demands.
- Lease Instead of Buy: For equipment and other major purchases, consider leasing instead of buying outright. This can help you preserve cash while still getting the necessary tools for your business. Many business owners aim to buy their own office unit as a means of investment because rather than pay for rent, the installments help to pay down the mortgage. It’s a great move if you have surplus of cash doing nothing and have no expansion plans. If putting the downpayment for the property means sacrificing expansion, it may be worthwhile to delay the purchase.
- Offer Incentives/Methods to encourage Early Payments: Encourage clients to pay early by offering small discounts or enabling credit card payment even though it comes with a cost. This can improve your cash inflow, even if it slightly reduces your profit margin.
- Monitor Cash Flow Regularly: Regularly review your cash flow statements to identify trends, spot potential issues early, and take corrective action before problems escalate. Download our cash flow budget template to assist you.
- Outsource Non-Core Functions: Consider outsourcing functions like payroll, IT, or marketing to reduce overhead costs and free up cash for core business activities. The pandemic has given rise to many best practices around managing a virtual team. Consider countries like Philippines if you are hiring virtual assistants, content creators, writers, customer service personnels.
- Seek Professional Advice: Don’t hesitate to seek help from a cash flow consultancy. Experts can provide tailored advice and strategies to improve your cash flow management that can be a make or break for your business.
Taking Action
Understanding the difference between cash flow and profit is essential, but knowing won’t solve your cash flow challenges. Taking action is crucial. By implementing the hacks and tips shared above, you can improve your cash flow management and ensure your business thrives.
Don’t let cash flow issues hold your business back and take the first step towards financial stability and growth.
While profit indicates your business’s overall financial gain, cash flow provides a more immediate and accurate picture of its financial health. By understanding and managing both effectively, you can ensure your SME not only survives but thrives in Singapore’s competitive business landscape. Take control of your cash flow today and secure a brighter future for your business.