3.8 - Cash Flow
The difference between cash flow and profit
Cash flow and profit are distinct financial concepts that both play vital roles in business operations, but they measure different aspects of financial health.
Cash flow
Cash flow tracks the actual movement of money into and out of a business. It focuses on the availability of liquid funds to meet immediate needs, such as paying suppliers or staff.
Profit
Profit is the amount left after subtracting all costs from revenue generated by sales. It indicates overall financial success but does not account for the timing of when cash is actually received or spent.
How cash flow and profit can differ
- Profit might be recorded when a sale occurs, even if payment is delayed (e.g., through credit terms), meaning cash may not be available immediately.
- A business can show a profit but have negative cash flow if expenses are paid before revenue is collected.
- Conversely, positive cash flow is possible even with a loss.
- Profitable businesses can face bankruptcy if cash flow is negative and they cannot pay ongoing costs, highlighting why cash flow management is often more critical for small businesses in the short term.
- Over the long term, sustained profitability is essential alongside effective cash flow control to ensure survival and growth.
The importance of working capital
Working capital represents the funds available for a business's day-to-day operations. It is crucial for maintaining smooth trading activities and avoiding disruptions.
Definition and calculation of working capital
Working capital is calculated as the difference between current assets (such as cash, stock, and money owed by customers) and current liabilities (such as short-term debts and bills due). It appears as net current assets on a balance sheet.
Role of working capital in business operations
- It enables businesses to purchase materials, pay wages, cover marketing expenses, and settle invoices promptly.
- Without adequate working capital, a business cannot function effectively or continue trading.
- The working capital cycle describes the time between paying for production costs and receiving cash from sales.
- Businesses with quick cash receipts have short cycles.
- Those with long production times and credit-based sales experience longer cycles.
Connection to long-term business sustainability
Businesses must balance short-term cash needs with long-term investments in assets like equipment or premises. Failing to invest can lead to decline, while excessive spending without cash reserves risks insolvency.
Components and calculation of cash flow
Cash flow involves tracking money entering and leaving a business, providing insight into its ability to meet financial obligations.
Cash inflows
- Primarily from sales of goods or services.
- Additional inflows can come from loans, investments, or selling assets.
Cash outflows
- Payments for operational expenses, including raw materials, employee wages, utility bills, insurance, and rent.
- Capital spending on fixed assets, like buildings or machinery, which creates an immediate outflow but provides benefits over time.
Formula for net cash flow
Where:
- Cash inflows = Money received (£)
- Cash outflows = Money paid out (£)
Positive net cash flow occurs when inflows exceed outflows, indicating sufficient funds. Negative net cash flow happens when outflows are greater, signalling potential issues in paying bills.
Cash flow forecasting
Cash flow forecasting predicts future movements of money in and out of a business, typically over periods like six or twelve months. It helps anticipate shortages and plan accordingly.
Key elements in a cash flow forecast
- Opening balance - Cash available at the start of the period, which is the closing balance from the previous period.
- Net cash flow - The difference between inflows and outflows for the current period.
- Closing balance - Cash remaining at the end of the period.
Formula for closing balance
Where:
- Opening balance = Cash at period start (£)
- Net cash flow = Inflows minus outflows (£)
Forecasts can be affected by internal issues, like poor planning, or external factors, such as fluctuating demand.
Worked example - Calculating closing balance from a cash flow forecast
A business begins May with an opening balance of £3,500. During the month, total inflows are £10,500 and total outflows are £7,200. Calculate the net cash flow and closing balance for May.
Step 1: Identify the values
- Opening balance = £3,500
- Total inflows = £10,500
- Total outflows = £7,200
Step 2: Calculate net cash flow
Step 3: Calculate closing balance
Causes of cash flow problems and ways to improve cash flow
Cash flow issues can arise from various internal and external factors, leading to difficulties in meeting obligations. Addressing them involves strategies to boost inflows, cut outflows, or secure extra funds.
Common causes of cash flow problems
- Sales falling below expectations.
- Production costs exceeding budgets.
- Unforeseen expenses.
- Delays in customer payments.
- Customers failing to pay debts.
- Holding too much unsold stock.
Strategies to reduce cash outflows
- Negotiate better credit terms with suppliers to delay payments.
- Reduce credit periods offered to customers.
- Provide discounts for prompt payments.
- Secure lower prices through bulk purchases.
- Opt for leasing equipment instead of buying.
- Maintain minimal stock levels to avoid excess.
- Bargain for reduced rent or move to cheaper premises.
Strategies to improve cash inflows
- Increase marketing to drive sales.
- Raise prices on products with loyal customers.
- Lower prices to compete in sensitive markets.
- Refine the range of products offered.
Options for additional financing
- Arrange bank overdrafts or loans, though these incur interest.
- Form partnerships to inject more capital.
- Sell off unused or outdated assets.
- As a last resort, dispose of key assets like vehicles or buildings.