6.4 - Cash Flow: Introduction
The difference between cash and profit
Cash and profit are distinct concepts in business finance, even though they are interconnected.
Cash refers to the money immediately available for a business to spend. Profit, on the other hand, is the surplus remaining after all expenses have been deducted from total revenue. A business generates profit when its income exceeds its spending over a period.
It is possible for a business to be profitable overall but still face cash shortages. This can happen if cash is tied up in assets, leaving insufficient funds for day-to-day payments. Conversely, a business might have positive cash flow but not be profitable.
Cash inflows, outflows, and net cash flow
Cash flow describes the movement of money into and out of a business during a specific period.
Cash inflows
Cash inflows occur when money enters the business. Examples include revenue from selling goods or services.
Cash outflows
Cash outflows happen when money leaves the business to cover expenses. Examples include purchasing materials or paying wages.
Net cash flow
Net cash flow is the difference between total inflows and outflows over a time period.
Types of net cash flow:
- Positive net cash flow - This arises when inflows exceed outflows, ensuring the business can easily cover payments. However, excessive positive cash flow might indicate missed opportunities, such as not investing in new equipment.
- Negative net cash flow - This occurs when outflows surpass inflows, potentially leading to difficulties in paying bills. Businesses may need to arrange additional finance, like an overdraft, to manage this.
Positive cash flow does not guarantee profit.
The purpose of cash flow forecasts
A cash flow forecast is a forward-looking tool that predicts the movement of money into and out of a business over future periods. It helps businesses prepare for potential financial challenges.
Benefits of cash flow forecasts
- Anticipating liquidity issues - Forecasts highlight periods when cash might be low, allowing businesses to arrange short-term finance like overdrafts in advance.
- Monitoring unexpected changes - By comparing actual cash flows to the forecast, businesses can assess the impact of surprises.
- Linking to budgets - Forecasts are based on budgets, which estimate expected revenues and expenses, providing a realistic view of financial health.
- Planning for negative cash flow - Identifying gaps enables proactive steps to maintain stability.
The structure of cash flow forecasts
Cash flow forecasts are typically presented in a table format, showing inflows, outflows, and balances over successive periods. Negative figures are often shown in brackets for clarity.
Example cash flow forecast
| Item | January (£) | February (£) | March (£) |
|---|---|---|---|
| Total inflows | 15,000 | 12,000 | 14,500 |
| Total outflows | 11,000 | 13,000 | 13,800 |
| Net cash flow | 4,000 | (1,000) | 700 |
| Opening balance | 2,000 | 6,000 | 5,000 |
| Closing balance | 6,000 | 5,000 | 5,700 |
This table illustrates how balances evolve, with negative net cash flow in February requiring careful management.
Calculating net cash flow and closing balance
Accurate calculations in cash flow forecasts ensure reliable predictions. The key formulas focus on net cash flow and closing balance.
Formula for net cash flow
Formula for closing balance
Worked example - Calculating net cash flow and closing balance
A business starts March with an opening balance of £4,500. During the month, it expects total inflows of £13,500 and total outflows of £12,900. Calculate the net cash flow and closing balance for March.
Step 1: Identify the values
- Opening balance = £4,500
- Total inflows = £13,500
- Total outflows = £12,900
Step 2: Calculate net cash flow