A Crash Course in Accounting 101
By Karen E. Klein
Q: What is the difference between cash flow and profits?
-- O.J., San Diego A:
Q: What is the difference between cash flow and profits? -- O.J., San Diego
A:Sounds like some straight definitions are in order.
"Cash flow" is the money that enters and exits a business through receipts, payments, drawings, and cash sales. "Profit" is total revenue less total expenses for a period of time calculated in accordance with generally accepted accounting principles.
So, cash flow is generally the "cash in, cash out" fluctuation that every business experiences as revenues come in, accounts are collected, salaries are distributed, and expenses are paid out. A company's cash flow is an important planning tool and it should be charted on a monthly basis and projected out over several months.
It's trickier when you're talking about net profit, which is more complicated and depends on what accounting method a company uses, as well as the items on which cash is expended.
"Many of my clients confuse cash flows and net profits, especially toward the end of the year when they are busy estimating what their tax liabilities might be," says Gregg R. Wind, a CPA based in Marina del Rey, Calif. "They typically think they have to spend all their money before the end of the year so that their bank balance is at zero. They equate no money with no profit, but that isn't necessarily true."
Certain expenditures that require cash don't necessarily translate into tax deductions, Wind says, and some tax deductions don't require cash outlays. Money spent on a deposit for office space, for example, is not generally deductible if the funds can reasonably be expected to be returned at the end of the lease. But the payment reduces cash flow, so the amount is "capitalized" and carried on the balance sheet as an asset.
LEARN THE RULES.
Conversely, depreciation produces a tax deduction, but may not require a current cash outlay. So, if a piece of equipment costs $7,000 up front, it could produce a write-off of $1,000 every year for seven years with no expenditure required to produce the tax deduction after that initial purchase.
Experts generally recommend that business owners be familiar enough with basic accounting to master these fine points. Trying to run a business without fairly sophisticated financial know-how -- even with the help of software, templates, and professionals -- is like trying to play a game without knowing the rules. And you're very unlikely to win.
Check into your local community college or adult school and sign up to do some number-crunching. Your business will be very glad that you did.
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