This is part of a series of the Top 10 Bookkeeping Mistakes Small Businesses make.  To read the others, click here.

Confusing profits with cash flow has been left to the last, the tenth of the top ten bookkeeping mistakes – but it’s a really important one.  You tend to remember the first and the last things you hear, so if you can remember that you don’t have to do your bookkeeping yourself (Bookkeeping Mistake 1) and that there’s a big difference between profits and cash flow, you’ll be doing a lot for your small business.

Profits have to do more with the long-term view of your business.  Over time, are you making money (profit) or spending money (loss)?

Cash flow, on the other hand, simply describes when and how cash is coming in and going out.  You might have a positive cash flow today when two big customers pay you, and then in three days’ time have a very negative cash flow because your taxes are due.

So, what are the differences? Why is it so easy, confusing profits with cash flow?

A business can have positive cash flow in the short term but still be unprofitable. 

Just because cash is pouring in right now, today or this month, doesn’t mean it will continue to do so.  Here are a few examples of why your cash flow might look excellent today, but your overall profit does not:

You ran an advertising scheme that brought in quick cash, but you’ll have to do the work or provide the product over the longer term.  A good example of this is LivingSocial or Groupon.  You might use these to advertise a particular product or special, and get a whole chunk of money right away (less the fees you have to pay to these companies!).  Perhaps you’re a restaurant, so 1,000 people purchased your deal, and you got all that money in right away.  But then over the next few months as these people come trickling in, your initial money has now been spent and yet you still have to pay for the food, drink, chef and cook salaries, and more.

Depreciation is another reason that your business might be showing a net loss (unprofitable), but still have a good cash flow.  When you purchase equipment or assets, you need to record a depreciation expense each year to show how the value of that equipment is decreasing over time.  So this affects your overall profit, because there’s an expense there, but it’s not coming out of your actual cash or your bank account, so you’re fooled into thinking everything is just fine.

A business can have negative cash flow in the short term but still be profitable in the long term.

This may happen because you have to pay your suppliers right away, but you have to wait for your customers to pay you when they’re ready.

An example of this might be an IT company who hires a specialist consultant to help with a project, to give some specific expertise in an area the IT company isn’t as familiar with.  And perhaps the specialist consultant requires payment up front. So, the IT company invoices their customer for the work, but before the customer has paid, the company has to pay the specialist consultant their fees.  Before the customer pays its invoice, the bookkeeping will show a negative cash flow; but once the invoice is paid, and more has come in than has gone out for this project, everything looks (and is) very profitable.

Another example is the purchase of a major asset or perhaps an office building.  Your cash flow could decrease massively if you purchase it in cash, but your profits are unchanged because you’re essentially “trading assets”.  The asset of cash has been traded for the asset of a building.

There are other reasons, but hopefully this gives you an idea of why it’s not always a terrible thing for your business in the long run.

Make sure you talk to your accountant and keep your bookkeeping up to date, though – you don’t want to just presume everything will work out perfectly.  In our example above, what if the customer was unhappy and refused to pay a portion of their invoice?  The payment to the specialist consultant has already gone, and the profits are then negative.

We’d recommend that you review all your financial statements – profit and loss, balance sheet, management accounts – on at least a quarterly basis.  Monthly is even better. That way, if you’re keeping your bookkeeping up to scratch, you can have a clear sense of the true situation your business is in, regardless of the positivity or negativity of your cash flow.