What is the difference between cash as a medium of exchange and profits as a measure of economic value? In this article, we’ll explore the fundamentals behind these two concepts. Leveraging principles from economics, business management, finance and psychology to conclude that profit is essentially an accounting concept while cash can be defined by its physical properties.
The “difference between cash and profit a level business” is the difference between what you have in your bank account and how much money you make. The first is cash, the second is profits. Cash includes all of your money that you have on hand at any given time, while profits are all of the money that you’ve made after paying for expenses to run your business.
Cash reigns supreme. You’ve probably heard it before, but do you truly understand what it means?
I studied how to handle cash flow in a classroom environment in business school, but it didn’t truly sink in until years later, when I was starting my own company. My cash flow decreased as my sales and earnings increased. What had previously been a classroom experiment was suddenly becoming a reality as I found myself on the verge of going bankrupt and missing payment, despite the fact that company seemed to be flourishing.
In the decades afterwards, I’ve seen that many of us fall into the same trap that I did: we think in terms of profits, but we spend in terms of dollars. Our society pushes us to think in this manner; it’s ingrained in us. The traditional business strategy on a napkin is to sell something for a lot more money than it cost you to make it. That should be adequate in the long run, but that isn’t always the case.
As a result, the moral of this tale is to do as I say rather than as I did. Keep an eye on your financial flow. Profits should not be confused with money. I was able to claw my way out of the short-term cash flow issue, but it required more mortgages and a lot of credit card debt.
The Differences Between Cash, Profits, and Revenue
Cash is an issue in business because we tend to take it for granted. We think in terms of profit, yet we spend money. The problem is that profits and cash are not the same thing.
What exactly are profits?
By deducting costs from sales, profits are determined. It makes no difference whether your client has paid you or if you have paid your bills. When you send out your invoice, you account for your sales. Expenses are the same way; you may record an expenditure even if you haven’t paid the bill yet.
What exactly is revenue?
The term “revenue” refers to the amount of money that enters the company. It’s the same as sales for most accounting and financial analysis reasons. However, income may also include asset sales as well as money received via loans and investments.
What exactly is cash?
Cash, on the other hand, is the real money you have on hand, in your bank account, to pay your expenses.
Profits are deceiving prophets.
Basic financial and accounting rules are at the root of the problem with comprehending the distinction between cash and earnings. The profit and loss statement, often known as an income statement, is a commercial practice that exists across the Western world. It depicts the company’s performance over a particular time period, typically a month, a quarter (three months), or a year.
It begins with sales at the top and moves down through direct costs (also known as unit costs and costs of goods sold, or COGS). Gross margin is calculated by subtracting direct expenses from revenues.
Then it includes expenditures, including both fixed and variable costs like as rent and wages, as well as marketing and promotional costs. Interest and taxes are technically both expenditures, although they are often reported separately from operational expenses. And the profit is calculated by deducting the costs (including interest and taxes) from the gross margin at the bottom.
This is the granddaddy of all accounting statements, and it sets the tone for a lot of business conversations. It also shapes our lexicon: we speak to “sales” as “the top line,” and “profits” as “the bottom line.”
But here’s the rub: profit and loss seem to be the whole health of the company, but they aren’t.
How waiting to get paid affects earnings and cash flow when selling on credit
The products or services are delivered to a company customer or client, accompanied with an invoice. The payment will be made later. This is quite frequent in B2B transactions, and it implies that the amount of the invoice is included in the month’s sales and is recorded as sales—but it isn’t really cash in the bank.
Instead, until the check comes and is deposited into the bank, that amount is placed in an accounting category called accounts receivable. Collection days, or collection period, is the average time between sending an invoice and collecting payment. The issue that companies confront is that all of their accounts receivable money shows up in earnings as sales but not in their bank accounts. You are unable to spend it.
Profitable companies may fail simply because they have too much money in accounts receivable and not enough in the bank—their bills aren’t paid on time. The funds appeared in sales but never made their way to the bank. Profitability did not, in the end, avert company collapse.
Purchasing items before selling them is known as inventory.
Most product companies, such as shops, must purchase the items they sell in advance of selling them. Manufacturers and assemblers must purchase components and supplies before creating and selling completed products, which may lead to cash flow issues.
Inventory refers to resale items, manufacturing supplies, and assembly components. Money spent on inventory does not show up in earnings until it is eventually sold—but once it is spent, it is gone.
Inventories management is important for cash flow in companies that rely on inventory. It’s all too easy to end up with money locked up in goods that either stays on the shelf for too long or never sells. Although the money has left the bank account, it does not appear on the profit and loss statement.
Bills: What you have in the bank vs what you owe
Accounts payable is the polar opposite of accounts receivable, and it refers to money owed to suppliers by a company.
Taking 30 days or longer to settle bills is beneficial to your cash flow. Every dollar in accounts payable is a $1 that counts as an expenditure and reduces earnings, but it is still a dollar in your bank account. Until you pay it out, you own that money. Expenses are deducted from profits when they are incurred, not when they are paid.
Payables are the polar opposite of receivables: you have your money in receivables, but you have your suppliers’ money in payables.
A case study on the distinction between cash and profits
Here’s an example to help you understand the difference between cash and profits: Garrett’s Bike Shop is a bicycle shop with annual sales of about $400,000 in a medium-sized local market.
The first graph below depicts important operational figures for the shop over the course of a few months. Sales, direct costs, expenditures, and profits are all visible.
Now let’s compare that to a simple cash flow projection based on the assumption that the store makes 90% of its sales on credit (“Net-60”) and that its customers pay their invoices two months later (which would be unusual for a bicycle store, but it’s the case for most existing business-to-business companies).
Also, suppose Garrett maintains approximately a month’s worth of sales in the shop as inventory that customers may purchase, and that he needs to acquire those goods before selling them. As you can see in the accompanying diagram, cash flow differs significantly from earnings.
In this instance, the gap between earnings and cash is more than $90,000 for a company that sells approximately $30,000 each month. That company would be successful, yet it would go bankrupt due to a shortage of capital.
The only difference between the two situations is cash flow, not sales, cost of sales, or expenditures. There are no pricing increases, no new workers, and no pay adjustments.
Here’s a visual representation of the difference:
The actual bottom line is to keep an eye on your cash flow.
The term “the bottom line” refers to earnings, which are the profit and loss statement’s bottom line. However, it has evolved to imply something like to a conclusion or the most significant outcome. That is why, for company owners, cash flow is more important than earnings.
There’s no way around it: even profitable businesses may run out of money owing to a lack of cash flow. You must consider cash flow as well as earnings while running a company.
Note from the editor: This article was last updated in 2020.
The “what is the difference between cash and profit tutor2u” is a question that many business owners are asking. The answer to this question can be found on the website of “The Difference Between Cash and Profit”.