There’s a saying that goes, “Revenue is vanity, profit is sanity, cash is king.” As a tax advisor, I’m always monitoring and managing tax situations for my clients. However, the ultimate goal of tax planning is to maximize net cash inflow. All the tax planning in the world won’t help your business or household if it’s bleeding cash. With that in mind, let’s talk about what cash flow is, how it differs from profitability, and why that matters.

What is cash flow?

Cash flow is money coming into your business or household (“sources”) and money going out to others (“uses”). Sources of cash include business revenues, paychecks, earnings on investments, loans, etc. Uses of cash include business expenses, household needs, purchases of financial and other assets, and loan repayments. When sources of cash exceed uses of cash, you have positive cash flow. When sources of cash do not exceed uses of cash, you have negative cash flow.

How does cash flow differ from profitability and net worth?

Positive cash flow isn’t the same as profitability, which is measured by subtracting expenses from revenue. For example, a business may have excess cash due to a bank loan, but if its expenses consistently exceed its revenues, continued business losses will eat up all that cash. Also, positive cash flow should not be confused with net worth. You can makea lot of money, but not havea lot of money if, for example, you spend all you make on non-income generating assets or day-to-day expenses. You’ve heard of HENRYs, right? High-Income, Not Rich Yet. There are also the HENRÉs – High-Income, Not Rich Ever. These folks have positive cash flow, but if they’re not setting any of it aside for a rainy day, they often have negative net worth.

By the same token, short-term negative cash flow doesn’t necessarily mean that you aren’t profitable or have a low net worth. Loan repayments, asset purchases, business seasonality, etc., may cause cash uses to exceed cash sources for a period of time. In and of themselves, these short-term cash flow fluctuations don’t present the full picture of a business’ or household’s financial health.

Cash flow issues may or may not be caused by lack of short-term profitability, but lack of profitability in the long-term will ultimately cause cash flow problems.

Why do these distinctions matter?

Why is it important to recognize the difference between profitability and cash flow? Because problems related to profitability and problems related to cash flow are not corrected the same way. For example, imagine that you own a pizza restaurant that has experienced a net loss (expenses in excess of revenue) for the last two months. Is this because your regular customers have gone on vacation for the summer? If so, then this a short-term cash flow concern that can be addressed with a bank line of credit, cutting back on staff during the slower months, and so on. If, however, your customers are patronizing the new pizza restaurant down the street, this increased competition will impact your long-term profitability. No amount of operating loans will help if you continue to do business as you always have. Instead, you’ll need to change up your menu, increase your marketing, consider moving to another location, etc.

As you’re looking at the financial situation of your household or business, ask yourself whether it is healthy or unhealthy right now. If healthy, is it because of one-off cash inflows such as a large bonus or a generous gift from a family member? These unplanned cash influxes must be managed carefully to avoid issues down the road. If your financial situation is unhealthy, is it due to short-term profitability issues or a more systemic cash flow problem? Starting with this question will help you decide how best to approach and remedy the situation. I encourage you to reach out to me if I can help with this in anyway.