So, your business is doing well and turning a healthy profit. Nothing to worry about, right? Not necessarily.
Many business owners conflate the concepts of profit and cash flow, which is understandable, but these are actually two different (albeit related) things.
In this article, we’ll explain the key differences between them, as well as how they work in tandem to support long-term growth.
Cash flow vs profit: what’s the difference?
The first step is understanding what separates cash flow from profit – and the unique function of each.
- Profit is what’s left after you deduct all your expenses from your total income
- Cash flow is the movement of money in and out of your business
A helpful way to think about it is that cash flow indicates your business’s immediate financial health, while profit indicates long-term sustainability.
Can a business make a profit and still struggle with cash flow?
Yes, it’s absolutely possible for a business to record a profit but still suffer from cash flow problems.
For example, let’s say you run a construction company and secure a £500,000 contract. You work out your costs and look set to make a really healthy profit.
The problem is that you won’t be paid until the end of the contract, so you’ll need to cover wages, suppliers, and subcontractors throughout the project – before you get any money in for it.
So even though the project is profitable, the business can still experience cash flow pressure if outgoing costs consistently run ahead of incoming payments.
Why is cash flow important?
If profit helps your business grow, cash flow keeps it running. Managing your cash flow will help you make sure you have cash on hand to cover ongoing expenses like supplier costs, payroll, rent, etc.
Not being able to pay your bills when they’re due can actually cost the business more money. If you need to rely on credit to make payments on time, this often comes with interest that needs repaying on top of the original amount you borrow.
You might even find you struggle to grow the business if you’re missing out on opportunities because of cash flow restrictions.
Plus, if you ever need funding, potential lenders and investors will use your cash flow to determine how reliable you are (i.e. how likely you are to be able to pay them back on time).
Why is cash flow forecasting important?
A cash flow forecast helps you to estimate when funds will come in and go out of your business over a particular period of time. This means you can hopefully avoid shortfalls by planning ahead.
For example, if it looks like you’ll have a cash gap at some point in the future (for example, because you’ve spotted patterns where things are quieter at particular times), you might:
- Start putting some money aside to fill the income gap
- Use special offers to encourage sales during that period
- Control spending leading up to it, so you’re not making any major (non-essential) purchses
How far forward should I look?
One important consideration for cash flow forecasting is how far into the future you wish to look. It’s generally useful to review your cash flow forecast on a monthly basis, but the frequency really depends on the nature of your business. You might want to consider hiring an accountant to help you do this.
Good bookkeeping software will often include cash flow forecasting tools which can make your life a whole lot easier!
Reasons cash flow might be negative in London
We all know how expensive London can be, and this is something to bear in mind when forecasting your cash flow as the owner of a London-based business.
Higher overheads and rising mortgage rates can significantly impact your ability to strike a healthy cash flow balance of in vs out.
Any suppliers you might have who are also based in London may have to delay invoices and such in order to take care of their own cash flow, and so there’s a knock-on effect.
There also tend to be longer payment cycles in the capital, which can obviously affect your cash flow. For example, some sectors like construction and media have 60-90 day terms (instead of the average, which is 30 days).
The important thing is to make sure you’re prepared for all this and know what you’re getting yourself into by choosing to operate a business in London.
Find more help with accounting and finance for your London-based business in our information centre.
