Unit 3 – Finance and Accounts
3.7 – Cash Flow
Cash flow is the movement of money in and out of a business. It's different from profit: a business can be profitable yet run out of cash. Good management of cash flow and working capital ensures ongoing operations and reduces risk of crisis.
Cash Flow: Key Concepts
- Cash inflow: Money coming into the business (e.g., sales revenue, loans, investments, asset sales).
- Cash outflow: Money going out (e.g., payments to suppliers, wages, bills, tax, loan repayments, buying assets).
- Net cash flow: The difference between inflows and outflows over a period.
Formula: \[ \text{Net Cash Flow} = \text{Total Cash Inflows} - \text{Total Cash Outflows} \] - Cash flow forecast: A projection of future cash inflows and outflows done to anticipate shortfalls or surpluses.
- Opening balance: The amount of cash held by the business at the start of a period.
- Closing balance: The amount of cash left at the end of a period.
Formula: \[ \text{Closing Balance} = \text{Opening Balance} + \text{Net Cash Flow} \] - Liquidity: The firm's ability to meet short-term debts as they come due (having enough cash on hand).
Investment, Profit & Cash
Investment:
- Spending on new assets (e.g., equipment, property, R&D) to create future benefits.
- Often involves a large cash outflow, with future inflows expected as returns.
Profit:
- Profit is the surplus after all costs are deducted from revenue: \[ \text{Profit} = \text{Total Revenue} - \text{Total Costs} \]
- Profit is not always the same as cash, as accounting includes non-cash items (e.g., credit sales, depreciation).
Working Capital: The funds a company needs for day-to-day operations.
- Funds tied up in inventory, receivables (debtors), less what the business owes short-term (payables).
- Formula: \[ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} \]
- Sufficient working capital = ability to pay bills on time and take advantage of business opportunities. Too little = risk of insolvency.
Liquidity Position
Liquidity measures a business’s ability to meet short-term debts.
- Measured by ratios such as:
- Current Ratio: \[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \] (Ideal usually 1.5–2:1)
- Acid Test (Quick Ratio): \[ \text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Stock}}{\text{Current Liabilities}} \] (Ideal usually >1:1)
- Liquidity problems may mean the firm cannot pay wages or suppliers—even if they show profit.
Cash Flow Example Table
| Month | Opening Balance | Inflows | Outflows | Net Cash Flow | Closing Balance |
|---|---|---|---|---|---|
| Jan | 5,000 | 8,000 | 7,200 | 800 | 5,800 |
| Feb | 5,800 | 8,200 | 7,600 | 600 | 6,400 |
| Mar | 6,400 | 9,000 | 8,200 | 800 | 7,200 |
Key Takeaways
- Cash flow is about liquidity, not profit—firms need regular inflows to pay their bills.
- Investment decisions affect cash outflows, profit (over time), and working capital.
- Profitability does not guarantee liquidity; both must be managed and analyzed.
- Use cash flow forecasts and ratios (current, acid test) to monitor and prevent cash flow problems.