When it comes to decision-making, whether for companies or investors, there are two figures they can use. These are the profits or cash flows of a company. However, some people tend to confuse the two and not be able to differentiate between them. Therefore, it is necessary to understand what these are.
What are Profits?
The profits of a company represent its income or earnings net of expenses. There are various types of profits that companies may have. These primarily include gross, operating, and net profits. However, companies may also calculate other types of profits based on the costs they deduct. The profits of a company show its income after deducting expenses from its revenues.
Two factors influence the profits of a company. Firstly, the revenues of a company play a crucial role in determining its profits. The higher the revenues of a company are, the higher its profits will be as well. Secondly, the expenses incurred by a company also dictate its profits. Therefore, the lower the expenses of a company are, the more its earnings will be.
What are Cash Flows?
The cash flows of a company represent all its income and expenses in monetary form. Cash flows play a crucial role in the success of a company. Just because a company is profitable, doesn’t mean it will also have proper cash flows. There are many examples of companies that have failed due to inept cash management despite being profitable.
The cash flows of a company influence its liquidity. Therefore, companies need to manage their cash flows for long-term success. Cash flows represent the changes in the cash and cash equivalent balances of a company. According to accounting, these are the assets of the company. Companies can classify their cash flows into three categories: operating, financing, and operating.
Are all Profits also Cash Flows?
The profits of a company represent its income. For a company that only transacts in cash, its profits will also be equal to its cash flows. However, for almost all businesses worldwide, the profits and cash flows are never the same. The primary reason why a company's profits and cash flows may not match is credit transactions.
A company that offers credit sales or makes credit purchases will always have profits different from its cash flows. Similarly, other factors such as bad debts or discounts may also affect a company’s cash flows from its operations. Likewise, all accrued transactions cause the profits and cash flows of a company to mismatch. Accrued transactions consist of transactions having cash flow timing differences, and companies must record due to accounting standards.
However, it does not imply that a company's cash flows do not relate to or depend on its profits. Companies that have higher profits will also generate more cash flows. The only difference in the profits and cash flows comes due to the timing. Similarly, profits are only one of the sources of cash flows for a business. Other operating, financing, or investing activities may also result in cash inflows or outflows.
Conclusion
Profits and cash flows are two crucial elements of the success of a company. The profits of a company represent its net income after deducting its expenses from its revenues. Cash flows, on the other hand, represent transactions that result in monetary inflows or outflows. While there are differences between profits and cash flows, they can still be interdependent.
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