3.7 Cash Flow
The Difference Between Cash and
Profit
• Cash: the lifeblood of a business because
every organization needs cash to keep
functioning
• Profit: the positive difference between a firm’s
total sales revenue and its total costs of
production.
• Are profit and cash the same thing?
The Difference Between Cash and
Profit
• If a firm sold $50,000 of goods in a month,
with 60% of its customers paying by cash, then
only $30,000 cash is received. The other 40%
(or $20,000) is not received until the end of
the credit period. What’s the sales revenue
made by the firm and what’s the cash inflow?
The Difference Between Cash and
Profit
• Is it possible for a firm to be profitable but
cash deficient? Why?
– Poor credit control
– The profitable business tries to expand too quickly
– Seasonal variation in demand  short-term
liquidity problem
• Is it possible to be cash rich but unprofitable?
The Working Capital Cycle
• Working capital: the cash or liquid assets
available for the daily running of a business.
– Funds available to pay for the immediate costs
and expenditure
– Lacking of working capital  insufficient cash to
fund routine operations
• Liquidity: how easily an asset can be turned
into cash
The Working Capital Cycle
• Which is the largest cause of business failure,
lack of profitability or insufficient working
capital?
– Inadequate working capital  insolvency 
liquidation of the firm  collapse of the business
• Insolvency: a situation where working capital
is insufficient to meet current liabilities
• Liquidation: company needs to sell off its
assets to repay as much of the money owed to
is creditors
The Working Capital Cycle
• Working capital = Current asset – Current
liabilities
• Current asset: the liquid resources belonging
to a business that are expected to be
converted to cash within the next 12 months
– Cash
– Debtor
– Stock
The Working Capital Cycle
• Current liabilities: the money that a business
owes that needs to be repaid within the next
12 months.
– Overdrafts
– Creditors
– Tax
The Working Capital Cycle
• There is a delay between paying for costs of
production and receiving the cash from selling
their products  production process takes
time
• Working capital cycle: the interval between
cash payments for costs of production and
cash receipts from customers
The Working Capital Cycle
Production
costs
Cash
Sales
Any drawbacks for
holding too much
cash and liquid
assets?
Cash Flow Forecasts
• Cash flow forecast: a financial document that
shows the expected movement of cash into
and out of a business, per time period
– Cash inflow
– Cash outflow
– Net cash flow
Cash Flow Forecasts
• Cash inflow:
– Sales revenue
– Payments made by debtors
– Loans from a bank
– Interest received from savings deposits
– Sale of fixed assets
– Rental income charged on property owned by the
business
Cash Flow Forecasts
• Cash outflows: cash that leaves a business
• Net cash flow: the difference between cash
inflows and cash outflows, per time period
Cash Flow Forecasts
• Reasons for cash flow forecasts:
– Banks and other lenders require a cash flow
forecast to help them assess the financial health
of the business seeking external finance
– Cash flow forecasts can help managers to
anticipate and identify periods of potential
liquidity problem
– Cash flow forecasts aid business planning
Cash Flow Forecasts
Cash Flow Forecasts
• Opening balance: the amount of cash at the
beginning of a trading period
• Closing balance: the amount of cash at the
end of trading period
Closing balance  Opening balance  Net cash flow
Cash Flow Forecasts
• Causes of cash flow problems:
– Overtrading: the situation occurs when a business
attempts to expand too quickly (or aggressively), without
the sufficient resources to do so.
– Overborrowing: the larger the proportion of capital raised
through external sources of finance, the higher the cash
outflow on loan interest payments
– Overstocking: business holds too much stock as a result of
ineffective stock control system
Cash Flow Forecasts
• Causes of cash flow problems:
– Poor credit control: a. offers customers an extended credit
period, leading the business to trade for long periods
without cash inflows; b. too many customers are offered
credit, which increases the chances of bad debts being
experienced.
– Unforeseen changes: unexpected and erratic changes in
demand can cause serious cash flow problems
Investment, Profit and Cash Flow
• Sell an investment  increase in cash flow
• Obtain finance for investment  cash inflow
improves liquidity position
• How investment is financed also affects the
cash flow position of a business
Strategies to Deal with Cash Flow
Problems
• Three generic ways to deal with cash flow
problems:
– Reducing cash outflows
– Improving cash inflows
– Seeking alternative sources of finance
Reducing Cash Outflows
• Seek preferential credit terms
– Limitation: Administrative costs and the time
needed to investigate and negotiate better deals
which might not results in significant differences
to the cash flow position of the firm
• Seek alternative suppliers
– Limitation: cheaper raw materials  lower quality
 change marketing strategies
Reducing Cash Outflows
• Better stock control
– Works well for manufacturers of mass product
– Not works well for businesses that offer a service
and do not hold much stock
• Reduce expenses
– Scrutinizing expenses can help to identify
overhead costs that can be reduced, without
compromising quality
• Leasing: rather than buying, reduces the
burden on cash flow
Improving Cash Inflows
• Tighter credit control
– Limit trade credit to customers or reduce credit
period
• Limitation: customers might switch to rivals due to the
worsened trade credit terms
– Debtors can be encouraged to pay earlier or on
time by offering incentives
– Accepting interim payments
Improving Cash Inflows
• Cash payments only
– Limitation: customers might prefer to buy from
competitors who offer trade credit
• Change pricing policy
– Offload excess stocks
– Works best for products that have lots of substitutes
or are at the end of their product life cycle
• Improved product portfolio
– Limitation: raises costs and risks, yet no guarantee of
higher net cash inflows
Seeking Alternative Sources of
Finance
Government
assistance
Overdraft
Debt
Factoring
Selling fixed
assets
Limitations of Cash Flow
Forecasting
• Marketing
• Human resources
• Operations
management
• Competitors
• Changing fashion and
tastes
• Economic change
• External shocks
Cash Flow and the CUEGIS
Concepts
• Contingency fund: set aside cash for
unexpected changes and emergency use.
– The greater the level of uncertainty faced by a
business, and the more exposed it is to change,
the higher its contingency fund tends to be
• Working capital is essential for many aspects
of business strategy:
– Human resources strategy
– Marketing strategy
– Production strategy