The question came up with another client just this week: what should we focus on; Profits or Cash Flow?
Let’s start by clearly stating what each of these is.
• Profits represent revenues less expenses generally on an accrual basis as presented on the Income Statement.
• Cash flow refers to the net of all cash receipts less cash expenses. Cash accounting. This is presented either on the Cash Flow Statement or the Cash Budget.
The correct answer is influenced by the situation.
• Is the need immediate or long-term?
• Are we talking payroll or shareholder return?
• Who is asking?
• Why are they asking the question?
Is the need immediate or long-term? If we need cash to pay an invoice, cash flow is more important. Yet over the long run, profits are needed to sustain cash flow.
Are we talking payroll or shareholder return? Payroll, and other actual expenses, are paid with cash flow. Shareholders usually aren’t focused on cash flow. They are looking at their own returns over time. The most common measure of this is the ratio of net income (profits) to equity; Return on Equity or ROE. We must calculate the profits to calculate this critical ratio.
Who is asking? If the question refers to a supplier, cash flow is the answer. This is what they get paid with. If the question comes from a banker reviewing your five-year loan request, they want to see the profits. Profits repay term loans.
Why are they asking the question? Intellectual curiosity, demand for payment or financial analysis? As you have already figured out, both profits & cash flow are important to every organization, yet they serve different purposes. We need both to function. Our financial statement presentation clearly demonstrates the amount of each if you know where to look.
But so what? Cash flow is critical to our short-term needs: paying today’s bills. Profits are critical to paying our long-term debts and leading to tomorrow’s cash flow. Plan both appropriately to run a good organization.