Cash flow measures the actual movement of cash into and out of a business, reflecting liquidity and available funds. In contrast, Profit (P&L) is the net income remaining after subtracting all expenses from revenue, indicating profitability. Profit is an accounting measure (accrual basis), while cash flow is the actual cash in the bank.
Both are equally important but in different situations. Cash flow is important in the short term because it can affect how a company can meet its financial obligations. Profits are critical for long-term success because they allow companies to expand and continue to operate.
What's the difference between cash flow and a profit and loss statement? A profit and loss statement (P&L) shows your business's profit over a period by subtracting expenses from revenue. A cash flow statement tracks the actual movement of money in and out of your bank account.
In this case, we want Cash Flow from Operations, or Free Cash Flow (which is equal to operating cash flow minus capital expenditures). Once cash flow is determined, the next step is dividing it by the net profit. That is the profit after interest, tax, and amortization.
Profit ≠ Cash Flow
Profit is an accounting concept. It reflects how much your revenue exceeds your expenses on paper. But it doesn't track when money actually enters or leaves the bank. That's where cash flow comes into play.
Cash flow is the movement of money in and out of a company. Net cash flow is calculated by subtracting total cash outflow from total cash inflow. A company's cash flow statement reports its sources and use of cash over a certain period of time.
Profit, on the other hand, only looks at the remaining balance after deducting expenses from revenue. It is possible for a business to have positive cash flow but no profit, and vice versa. For example, a business may have positive cash flow if it payments from customers promptly but incurs significant expenses.
A good cash flow ratio is generally above 1.0, indicating a company generates enough cash from operations to cover short-term liabilities, with higher ratios (like 1.25+) showing stronger liquidity, though what's "good" depends on the industry and specific ratio used (Operating Cash Flow Ratio, Cash Flow to Sales Ratio, or Debt to Free Cash Flow Ratio). Ratios below 1.0 suggest potential cash flow issues, while ratios significantly above 1.0 point to healthy financial standing, with a Debt to Free Cash Flow ratio between 1.0 and 2.0 often considered strong.
In an ideal world, both profit and cash flow would be in balance but that's simply not realistic. For example, it's possible for a company to be both profitable on paper and have a negative cash flow. Negative cash flow could hamper your business's ability to pay its expenses, expand, and grow.
The formula for calculating profit is:total revenue - total expenses = profitProfit is equal to the total amount of sales a business has made minus all of its direct and indirect costs. Some of the costs to include in this calculation include: staff wages.
According to the legendary investor Warren Buffett, free cash flow—the cash remaining after a company has covered expenses, interest, taxes, and long-term investments—is the most crucial valuation metric.
Cash Flow Statement Preparation in 4 Steps
Examples of cash inflows from transactions considered operating activities:
While the P&L evaluates profitability and spending trends, the cash flow assesses liquidity and cash health. Together, these reports help identify growth opportunities as well as potential issues so they can be addressed proactively.
To calculate cash flow, you primarily look at inflows versus outflows, often broken down into Operating, Investing, and Financing activities to get the overall Net Cash Flow, using formulas like Net Income + Non-Cash Expenses - Changes in Working Capital for operations, and subtracting Capital Expenditures from Operating Cash Flow to find Free Cash Flow.
Cash flow is essential to the survival of your business – it's (arguably) more important than profit in the short term. Profit may be essential in the long run, but businesses need cash to pay bills and operating costs. A business with good cash reserves can survive until it becomes profitable.
Cash flow is typically depicted as being positive (the business is taking in more cash than it's expending) or negative (the business is spending more cash than it's receiving).
The 70/20/10 rule for money is a simple budgeting guideline that splits your after-tax income into three categories: 70% for Needs (essentials like rent, groceries, bills), 20% for Savings & Investments (emergency funds, retirement), and 10% for Debt Repayment & Donations (extra debt payments or giving). It balances immediate living costs with long-term financial security, helping you cover necessities while building wealth and paying off liabilities.
Negative cash flow is when your business spends more than it earns over a given period, reducing the cash you have available for day-to-day operations. Common causes include late-paying customers, higher overhead costs, low profit margins, and growing too fast without enough working capital.
A business could make net profit while having negative cash flow. Earning revenue does not necessarily mean that the company has received cash immediately. The actual movement of cash may happen later. For instance, a company sold goods and accrued profit on the income statement but did not receive the money yet.
Common Multiples
Service businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple) Food businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple) Manufacturing businesses: 3.0 to 5.0+ (i.e., cash flow x 3.0-5.0+ multiple) Wholesale businesses: 2.0 to 4.0 (i.e., cash flow x 2.0-4.0 multiple)
Your business allows its clients to pay for its goods or services via a credit account (Cash Flows From Financing). When a customer pays with credit, the income statement reflects revenue but no cash is being added to the bank account.