Cash flow

📚The business management

Profit is not cash

Profit is revenue minus costs over a period, recorded when sales are made. Cash flow is the actual movement of money into and out of the business. They differ because:

• Credit sales: a sale counts as revenue now, but the cash arrives when the customer pays, perhaps 60 days later.
• Credit purchases: costs are recorded when goods are received but paid later.
• Capital expenditure: buying a machine uses a lot of cash now, but only the depreciation appears as a cost each year.
• Stock: cash spent on stock not yet sold is not yet a cost in the profit and loss account.
• Loans and share capital bring in cash but are not revenue; repaying loans uses cash but is not a cost.

So a profitable business can run out of cash (fast growth, generous credit to customers) and a loss-making one can have cash for a while (from a loan).

Working capital

Working capital is the money available for day-to-day operations. The working capital cycle is the time between paying for inputs and receiving cash from customers:

The liquidity position is the business’s ability to meet short-term obligations; measured by the current and acid test ratios (3.5) and monitored with cash flow forecasts.

Cash flow forecasts

A cash flow forecast predicts cash inflows and outflows, usually month by month, to show when the business may be short of cash. The standard layout:

Uses: identifies periods of shortage in time to arrange an overdraft; supports loan applications; helps plan the timing of big purchases; a benchmark to monitor actual cash flow. Limitations: based on predictions of sales and costs that may be wrong; unexpected events (a customer failing to pay, a price rise); only as good as the assumptions.

Investment, profit and cash flow

Investment (buying assets, launching products) uses cash first; profit and cash inflows come later, if at all. So a period of heavy investment usually weakens cash flow even when it will raise future profit. Growing businesses need finance for this gap, and poor timing of investment is a common cause of cash crises.

Dealing with cash flow problems

✏️Worked example

A surf school starts January with $15 000 in the bank. Its forecast cash inflows ($000) are 20, 18, 22, 30, 40 and 55 for January to June, rising into the busy season. Monthly outflows are $26 000, plus $30 000 in February for new boards. Calculate the closing balances and recommend how to manage the shortfall.

Jan: 15 + 20 − 26 = 9

Feb: 9 + 18 − 56 = −29

Mar: −29 + 22 − 26 = −33

Apr: −33 + 30 − 26 = −29

May: −29 + 40 − 26 = −15

Jun: −15 + 55 − 26 = 14

Recommendation: the shortage is temporary and caused by seasonality plus a one-off capital purchase. An overdraft facility of about $35 000 would cover the gap and is repaid by June. Better still, the boards (capital expenditure lasting several years) could be leased or bought with a medium-term loan, which removes most of the shortfall; the school could also delay the purchase to April or offer early-booking discounts to bring cash forward.

Check it. Each opening balance equals the previous closing balance; June’s closing balance equals the opening balance plus all inflows minus all outflows: 15 + 185 − 186 = 14.

Recommending a long-term loan for a short, seasonal gap (or an overdraft for a long-term asset). Match the finance to the cause and duration of the problem.