Cash Flow & Working Capital (DP IB

Business Management)

The difference between profit and cash flow

 Profit and cash are different financial terminologies

o Profit is calculated at a specific point in time

o While a company may be in profit, they may lack cash as some customers may
not actually have paid them yet

 Profit is the difference between revenue generated and total business costs during a
specific period of time

o Profit can be an important indicator of a company's financial health and long-

term sustainability as it helps to assess the effectiveness of a company's
operations

 Cash is measured by taking into account the full range of money flowing in and out of a
business

o This includes revenue from sales, operating expenses, investments,(Capital

(Machinery) Labour/Skilled Labour (Human Resources/Human Capital) loans
(Cash is not ready so even the richest of the business owners need to seek loans
from banks, and any other cash-related transactions

 A profitable business is likely to fail if it does not have sufficient cash

o Cash-poor businesses will struggle to pay suppliers

 E.g. Lifestyle retailer Joules announced plans to liquidate in December

2022 as a result of cash flow difficulties despite making a profit of £2.6
million during the previous year

Liquidity – Shortage of Assets – Problem with the Capital – Cannot keep

up with the changing Market Trends – A Huge Competitor – Recession
Situation
Working capital

 Working capital is the money that a business has available to fund its day to day
activities

 It is sometime included as net current assets on the Statement of Financial Position

 Working capital is calculated using the formula

Working capital = Current assets - Current liabilities

Managing working capital

 Working capital is described as the lifeblood of a business because a lack of working

capital often leads to business failure if the business cannot meet its immediate
financial obligations

o Cash is the most liquid of a business's current assets and can be used to settle
debts immediately

 Effective management of working capital involves careful cash management

o Debtors and stock are less liquid

o Businesses that are struggling with a lack of working capital may look to convert
these current assets into cash as quickly as possible (e.g. by selling the stock at
lower prices or by more purposefully chasing payment from customers)

o Requesting an extension of payment terms from suppliers can increase working

capital in the short term as cash remains in the business for longer

o Making use of short-term borrowing options such as overdrafts can improve a

businesses working capital situation as it can access more cash than it has in its
current account

 A business can have too much working capital

o If a business is holding large amounts of cash it is likely to be missing out on the

benefits of investing it in fixed assets or investments
 o This may represent a significant opportunity cost especially when interest rates
are high

o If a business is holding large amounts of stock it may incur extra storage costs
(e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for
other purposes

Examiner Tips and Tricks

A common exam error is the confusion between working capital and cash. Whilst working
capital includes cash, it also includes less liquid current assets (e.g. debtors and stock). These
less liquid assets cannot be used to pay bills and so, whilst a business may have a positive
working capital figure, it may still fail because it cannot meet its immediate financial
commitments.

Liquidity position

 The Statement of Financial Position contains the financial information required to draw
conclusions about the liquidity of the business

o Liquidity is the ability of a business to meet its short term commitments (e.g.
payments to creditors) with its available assets

o A business that cannot pay its bills will usually fail very quickly, even if they are
profitable

o Managing liquidity is a key way to manage risk in a business - and helps a

business to prepare for the unexpected

Cash flow forecasts

 A cash flow forecast is a prediction of the anticipated cash inflows and cash outflows,
typically for a six to twelve month period

 A detailed business plan should include a cash flow forecast that allows the business
owners to identify its financial needs

Key terminology and an example

 The net cash flow is calculated by subtracting total outflows from total inflows

 The opening balance is the previous month’s closing balance carried forward

 The closing balance is calculated by adding the net cash flow to the opening balance

Example start-up six-month cash flow forecast (£s)

 Overall, this cash flow forecast supports an application for the business to borrow
£6,000 in January to cover the initial low inflows, significant outflows and negative net
cash flow

 As sales increase from June, inflows are greater than outflows and the business has a
positive cash flow
  Should a loan be approved, the business will require any short-term sources of finance,
such as overdraft facilities

Month by month

 January

o The cash flow forecast assumes that the bank approves a £6,000 loan in January
(capital introduced)

o The opening balance of £500 has been introduced by the owner

o The business is expected to achieve sales of £2,600

o Total inflows are therefore expected to be £8,600 (£2,600 + £6,000)

o Total outflows are expected to be £4,770

o The Net Cash Flow is expected to be £3,830 (£8,600 - £4,770)

o January’s closing balance is expected to be £4,330 (£3,830 + £500)

 February

o The closing balance from January becomes the opening balance for February

o Sales of £2,800 as expected to be the business total inflows

o Total outflows are expected to be £4,414

o The Net Cash Flow is expected to be -£1,614 (£2,800 - £4,414)

o The closing balance is expected to be £2,716 (-£1,614 + £4,430)

 March

o The closing balance from February becomes the opening balance for March

o The business expects to achieve sales of £3,100 as its total inflows

o Total outflows are expected to be £4,524

o The Net Cash Flow is expected to be -£1,424 (£3,100 - £4,524)

o The closing balance is expected to be £1,292 (-£1,424 + £2,716)

 April

o The closing balance from March becomes the opening balance for April

o Sales of £4,600 are expected as the businesses total inflows

 o Total outflows are expected to be £5,076

o The Net Cash Flow is expected to be -£476 (£4,600 - £5,076)

o The closing balance is expected to be £816 (-£476 + £1,292)

 May

o The closing balance from April becomes the opening balance for May

o The business expects to achieve sales of £4,800 as its total inflows

o Total outflows are expected to be £4,976

o The Net Cash Flow is expected to be -£176 (£4,800- £4,976)

o The closing balance is expected to be £640 (-£176 + £816)

 June

o The closing balance from May becomes the opening balance for June

o Sales of £5,200 are the business's total inflows

o Total outflows are expected to be £5,026

o The Net Cash Flow is expected to be £174 (£5,200-£5,026)

o The closing balance is expected to be £814 (£174 + £640)

The café owner thinks that good weather will increase the volume of customers and decides to
appoint another full-time assistant in March. As a result, wages increase to an expected £31,000
per month

Calculate the closing balances in the cash flow forecast resulting from the changes above. [4]
Answer:
Note that this one change in the anticipated cost of wages impacts four other variables 1.
(opens in a new tab)Total (opens in a new tab) outflows 2. Net cash flow 3. Opening balance
(except March) 4. Closing balance

Strategies to Improve Cash Flow

The relationship between investment, profit and cash flow
 Business investment involves the purchase of assets that are expected to create value
over time
o E.g the purchase of new machinery will improve productivity or quality which
may allow the business to sell more items at a higher price and this increases
sales revenue
 Financial investment may include the purchase of shares, bonds or property with the
expectation that they will gain value over time
 o For some businesses this is an important source of income alongside their core
business activities
 E.g. US supermarket giant Walmart owns and leases over 10 thousand
residential and commercial properties worldwide which act as as
important added revenue stream for the brand
 Investment, profit and cash flow differ over the lifetime of a business

Cash flow and profit over time

Strategies to improve cash flow

 The best way to improve cash flow is to manage the business better

o Use cash flow forecasts to identify potential cash flow issues before they arise -
and take appropriate action
o Budget effectively and consider adopting zero budgeting to carefully control
spending
o Set clear financial objectives and look for ways to reduce outflows and increase
inflows wherever possible
 E.g. Global conglomerate 3M, maker of Post-it Notes announced in early
2023 that it intends to raise prices and cut about 6,000 jobs to improve its
profits and cash flow position

 A business can also have too much cash

o If a business is holding large amounts of cash it is likely to be missing out on the

benefits of investing it in fixed assets or investments
o This may represent a significant opportunity cost especially when interest rates
are high
Methods to improve cash flow