Cash Flow
The difference between profit and cash, working capital, cash flow forecasts, and strategies for cash flow problems.
- Explain the difference between profit and cash flow, and why a profitable business can fail
- Construct a cash flow forecast from raw data, including credit sales and one-off payments
- Calculate net cash flow and closing balance for each period
- Recommend and evaluate strategies to improve a business's cash flow position
Profit vs Cash Flow
One of the most important distinctions in finance: a business can be profitable but cash-poor, and a business can have positive cash flow but be unprofitable.
| Profit | Cash Flow | |
|---|---|---|
| Definition | Revenue minus all costs over a period | The actual movement of money into and out of the business |
| Timing | Recorded when a sale is made (even if not yet paid) | Recorded when money actually changes hands |
| Can be positive while the other is negative? | Yes — a business can profit on paper but run out of cash | Yes — e.g. a business receiving a cash loan is cash-positive but not profitable |
| Shown in | P&L account | Cash flow forecast / statement |
"Cash is king." Many businesses fail not because they are unprofitable, but because they run out of cash to pay immediate bills — even while customers owe them money. This is called a liquidity crisis.
Why a Profitable Business Can Have Cash Flow Problems
- Sales made on credit — revenue recorded now, cash received later
- Buying stock before it is sold — cash out before cash in
- Seasonal demand — costs continue year-round but revenue spikes in one period
- Rapid growth ("overtrading") — expanding too fast without sufficient working capital
- Large capital investments — cash spent upfront, return comes over years
Working Capital
Working capital is the day-to-day finance a business needs to fund its operations.
A business needs positive working capital to function. Working capital flows around the working capital cycle:
- Cash is used to buy raw materials / stock
- Stock is converted into finished goods (work-in-progress)
- Goods are sold — if on credit, debtors are created
- Debtors pay → cash returns to the business
The faster this cycle turns, the less working capital is needed. Slow cycles (slow stock turnover, slow debtor collection) tie up cash and strain liquidity.
Cash Flow Forecasts
A cash flow forecast shows expected cash inflows and outflows over a future period (usually month by month). It is a planning tool — not a record of what happened, but a prediction.
Structure of a Cash Flow Forecast
| Jan | Feb | Mar | |
|---|---|---|---|
| Cash inflows | |||
| Sales revenue | 12,000 | 15,000 | 14,000 |
| Loan received | 10,000 | — | — |
| Total inflows (A) | 22,000 | 15,000 | 14,000 |
| Cash outflows | |||
| Wages | 6,000 | 6,000 | 6,000 |
| Rent | 2,000 | 2,000 | 2,000 |
| Supplier payments | 8,000 | 9,000 | 7,000 |
| Total outflows (B) | 16,000 | 17,000 | 15,000 |
| Net cash flow (A−B) | 6,000 | (2,000) | (1,000) |
| Opening balance | 5,000 | 11,000 | 9,000 |
| Closing balance | 11,000 | 9,000 | 8,000 |
Figures in brackets = negative. Closing balance = Opening balance + Net cash flow.
Net cash flow: Total inflows minus total outflows for a period.
Opening balance: Cash held at the start of the period (= previous period's closing balance).
Closing balance: Cash held at the end of the period = opening balance + net cash flow.
The Relationship Between Investment, Profit and Cash Flow
Investing in new assets requires cash now, but generates profit and cash returns over time. This creates a temporary cash flow problem even for healthy businesses. Understanding this relationship helps managers plan financing needs before a crisis hits.
Strategies for Cash Flow Problems
| Strategy | How it helps | Drawback |
|---|---|---|
| Overdraft | Immediate access to cash; flexible | High interest; repayable on demand |
| Short-term loan | Provides lump sum to bridge shortfall | Interest costs; takes time to arrange |
| Reducing expenses | Frees up cash; improves net cash flow | May affect quality, staffing, or production |
| Chasing debtors | Brings in cash faster | May damage customer relationships |
| Delaying payments to creditors | Keeps cash in the business longer | Damages supplier relationships; may lose credit terms |
| Sale of assets | One-off injection of cash | Reduces productive capacity; may be hard to reverse |
| Sale and leaseback | Raises cash while retaining use of asset | Ongoing lease payments; no longer owns the asset |
| Renegotiating trade credit terms | More time to pay suppliers | Supplier may refuse or reduce credit terms in future |
- Profit ≠ cash flow — a profitable business can still run out of cash
- Working capital = current assets − current liabilities
- Cash flow forecast: total inflows − total outflows = net cash flow
- Closing balance = opening balance + net cash flow
- Strategies: overdraft, loan, reduce expenses, chase debtors, delay creditors, sell assets
- Investment requires cash upfront; returns come over time
| April | May | June | |
|---|---|---|---|
| Total inflows | $18,000 | $9,000 | $14,000 |
| Total outflows | $14,000 | $16,000 | $12,000 |
| Net cash flow | ? | ? | ? |
| Opening balance | $2,000 | ? | ? |
| Closing balance | ? | ? | ? |
Show answer
| April | May | June | |
|---|---|---|---|
| Net cash flow | +$4,000 | −$7,000 | +$2,000 |
| Opening balance | $2,000 | $6,000 | −$1,000 |
| Closing balance | $6,000 | −$1,000 | +$1,000 |
May has a negative closing balance of −$1,000. Strategies include arranging an overdraft to cover the shortfall in May, or deferring some May outflows to June if possible.
Common mistake: Confusing net cash flow with closing balance. Closing balance = opening balance + net cash flow. Net cash flow alone tells you the change for the period; the closing balance is the cumulative position. A negative net cash flow doesn't mean the closing balance is negative — it depends on what the opening balance was.
Show answer
Rapid growth (overtrading) creates cash flow problems because the business must invest cash before revenue arrives. It must hire staff, buy stock, and expand premises ahead of the additional sales. Credit sales mean revenue is recorded in the accounts but cash may not arrive for 30–60 days. The business may be profitable on paper but unable to pay its immediate obligations. This is why fast-growing businesses often need external finance even when trading well.
Common mistake: Saying "the business is making a loss" when describing a cash flow problem. Profit and cash flow are separate — the question specifically says the business is profitable. The answer must explain the timing gap between earning profit and receiving cash.
Lauren owns Alpine Adventures. On 1 November 2024 she forecast cash flow for December–March.
Opening balance (1 Dec): $1,500
Forecast revenue: Dec $10,000 | Jan $20,000 | Feb $24,000 | Mar $12,000
Payment terms: 60% cash in month of sale; 40% credit, received one month later
Outflows: Rent $2,000/month; Wages = 30% of current month's revenue; New skis $8,000 in December (one-off); Electricity $1,200 paid in March only
(a) Prepare a cash flow forecast for December–March. Show all workings.
(b) Identify any month(s) with a negative closing balance. What is causing the problem?
(c) Compare AA's liquidity position in December vs. March.
(d) Suggest two strategies Lauren could use to address the December cash flow problem. [12 marks]
Show answer
(a) Cash Flow Forecast:
| Dec | Jan | Feb | Mar | |
|---|---|---|---|---|
| Opening Balance | $1,500 | ($5,500) | $2,500 | $15,700 |
| Cash sales (60%) | $6,000 | $12,000 | $14,400 | $7,200 |
| Credit receipts (prev month 40%) | $0 | $4,000 | $8,000 | $9,600 |
| Total Inflows | $6,000 | $16,000 | $22,400 | $16,800 |
| Rent | $2,000 | $2,000 | $2,000 | $2,000 |
| Wages (30%) | $3,000 | $6,000 | $7,200 | $3,600 |
| New Skis | $8,000 | — | — | — |
| Electricity | — | — | — | $1,200 |
| Total Outflows | $13,000 | $8,000 | $9,200 | $6,800 |
| Net Cash Flow | ($7,000) | $8,000 | $13,200 | $10,000 |
| Closing Balance | ($5,500) | $2,500 | $15,700 | $25,700 |
(b) December has a negative closing balance of ($5,500). The cause is the one-off $8,000 ski purchase combined with the fact that 40% of December sales are only received in January — high outflow meets delayed inflow.
(c) December: illiquid — closing balance of ($5,500), unable to meet obligations. March: strong liquidity — closing balance of $25,700. The seasonal nature of the business means the early months are cash-poor despite being profitable across the season.
(d) Any two: arrange an overdraft facility to cover December; delay the ski purchase to January when cash is positive; negotiate with supplier to buy on trade credit; increase proportion of customers paying cash upfront.
Common mistake: In credit sales questions, students often include 100% of revenue as a cash inflow in the month it is earned. When a question states that a proportion is on credit, only the cash portion arrives that month — the credit portion arrives the following month. Track these separately in the forecast.