3.4 - Cash Flow & Credit
The difference between cash, profit, and assets
Cash and profit are linked but separate ideas in business finance. A firm might generate profit overall but still face cash shortages if funds are tied up elsewhere.
Cash
Cash is the money a business has available right away for spending. It includes physical notes, coins, and funds in bank accounts that can be used immediately to cover expenses like wages, supplier bills, or regular overheads such as rent and utilities.
Profit
Profit is what remains after subtracting all expenses from total revenue. It shows if a business is earning more than it spends overall, but it does not indicate the amount of ready money available at any moment.
Assets
Assets are items of value owned by the business, including equipment, property, vehicles, or amounts owed by customers (debtors). Unlike cash, assets are not always quickly convertible to spendable funds.
A business can be profitable but short on cash if profits are invested in assets or if payments from sales are delayed.
The features and importance of cash flow
Cash flow tracks the movement of money entering and leaving a business during a set period. It is essential for ensuring a firm can meet its financial commitments without disruption.
The components of cash flow
- Cash inflow - Money coming into the business, such as revenue from sales, loans obtained, or proceeds from asset sales.
- Cash outflow - Money leaving the business, including payments for materials, wages, rent, utilities, and loan repayments.
- Net cash flow - The difference between inflows and outflows over a period.
Formula for net cash flow
The significance of positive and negative cash flow
- Positive cash flow - Happens when inflows exceed outflows, allowing the business to pay bills easily. However, it might indicate missed chances to invest in growth, like new machinery.
- Negative cash flow - Occurs when outflows surpass inflows, risking inability to meet payments and potential insolvency (failure due to unpaid debts).
Positive cash flow differs from profit; a firm can be profitable but have negative cash flow if inflows are timed poorly relative to outflows.
The purpose and structure of cash flow forecasts
A cash flow forecast predicts future inflows and outflows, helping businesses spot potential shortages and plan accordingly. It draws from a budget, which estimates likely revenues and expenses.
Uses of a cash flow forecast
- Identifying shortages - Highlights periods of low cash, enabling arrangements for short-term finance to avoid insolvency or forced asset sales.
- Avoiding failure - Ensures the business can cover debts and ongoing costs.
- Supporting planning - Guides decisions on when to seek extra funding or delay expenditures.
The main elements of a cash flow forecast
| Term | Definition |
|---|---|
| Total receipts | All cash inflows (e.g. sales revenue, loans, asset sales) for the period |
| Total payments | All cash outflows (e.g. supplier payments, wages, rent, loan repayments) |
| Net cash flow | Inflows minus outflows for the period |
| Opening balance | Cash available at the period's start (closing balance from the prior period) |
| Closing balance | Cash at the period's end (opening balance plus net cash flow) |
Formula for closing balance
Example cash flow forecast
| Jan | Feb | Mar | Apr | May | Jun | |
|---|---|---|---|---|---|---|
| Total receipts (inflow) | 14,000 | 10,000 | 6,000 | 11,000 | 12,000 | 8,000 |
| Total payments (outflow) | 9,000 | 10,500 | 9,500 | 8,500 | 11,000 | 10,000 |
| Net cash flow | 5,000 | (500) | (3,500) | 2,500 | 1,000 | (2,000) |
| Opening balance | 1,500 | 6,500 | 6,000 | 2,500 | 5,000 | 6,000 |
| Closing balance | 6,500 | 6,000 | 2,500 | 5,000 | 6,000 | 4,000 |
Numbers in brackets are negative. This forecast shows negative net cash flow in February, March, and June, indicating times when extra finance might be needed.
Worked example - Calculating closing balance from a cash flow forecast
A business begins March with an opening balance of £3,000. In March, total receipts are £5,500 and total payments are £9,000. Calculate the net cash flow and closing balance for March.
Step 1: Identify the values
- Opening balance = £3,000
- Total receipts = £5,500
- Total payments = £9,000
Step 2: Apply the net cash flow formula
Step 3: Apply the closing balance formula
Step 4: Interpretation
The closing balance of -£500 means the business would need extra finance to cover the shortfall at the end of March.
The impact of credit terms on business cash flow
Credit terms specify the time customers have to pay after a purchase, which can delay inflows and affect overall cash flow timing.
How credit terms affect cash flow
- Immediate payment - Cash enters the business at the sale point, aligning inflows closely with sales.
- Extended credit - Payment delays (e.g. two months) postpone inflows, even if sales are recorded immediately. This can create gaps where outflows occur before inflows, leading to temporary shortages.
Comparing cash flow with and without credit terms
| Oct | Nov | Dec | Jan | Feb | Mar | |
|---|---|---|---|---|---|---|
| Sales made this month (for future receipt) | 1,000 | 2,000 | 10,000 | 400 | 600 | 400 |
| Total receipts (actual cash inflow) | 1,000 | 2,000 | 10,000 | 400 | 600 | 400 |
| Total payments (cash outflow) | 2,500 | 3,500 | 1,800 | 300 | 250 | 200 |
| Net cash flow | (1,500) | (1,500) | 8,200 | 100 | 350 | 200 |
| Opening balance | 2,000 | 500 | (1,000) | 7,200 | 7,300 | 7,650 |
| Closing balance | 500 | (1,000) | 7,200 | 7,300 | 7,650 | 7,850 |
This table assumes immediate payment. Now compare with two-month credit:
| Oct | Nov | Dec | Jan | Feb | Mar | |
|---|---|---|---|---|---|---|
| Sales made this month (for payment in two months) | 1,000 | 2,000 | 10,000 | 400 | 600 | 400 |
| Total receipts (cash inflow) | 300 | 300 | 1,000 | 2,000 | 10,000 | 400 |
| Total payments (cash outflow) | 2,500 | 3,500 | 1,800 | 300 | 250 | 200 |
| Net cash flow | (2,200) | (3,200) | (800) | 1,700 | 9,750 | 200 |
| Opening balance | 2,000 | (200) | (3,400) | (4,200) | (2,500) | 7,250 |
| Closing balance | (200) | (3,400) | (4,200) | (2,500) | 7,250 | 7,450 |
With credit, inflows lag behind sales, leading to negative net cash flow in more months (three here) compared to immediate payment (two months). Businesses may need to arrange finance for longer periods when offering credit.