3.7 Cash flow

Profit is revenue minus the costs recognised for a period; cash flow tracks money actually entering and leaving the business. A firm can report profit while lacking cash because customers have not paid or cash is tied up elsewhere.

Cash-flow forecasts separate inflows, outflows, net cash flow, opening balance and closing balance. Net cash flow = total inflows − total outflows; closing balance = opening balance + net cash flow, and it becomes the next period’s opening balance.

If a month has £2,800 inflows and £4,414 outflows, net cash flow is −£1,614. A positive opening balance can absorb the shortfall, but a later negative closing balance signals when finance or a change in timing is needed.

Profit is not cash and a forecast is not a guarantee. Check collection timing, loan receipts, supplier payments and assumptions before deciding whether the business is safe.

Working capital = current assets − current liabilities. It funds day-to-day activity, but current assets differ in liquidity: cash can settle a bill now, while stock or debtors must first be converted.

A business can be profitable yet cash-poor if it offers long customer credit or holds too much stock. Working-capital management therefore links inventory, receivables, payables and short-term borrowing to the operating cycle.

If current assets are £11.2m and current liabilities £11.5m, working capital is −£0.3m. The firm may need faster collection, stock reduction or negotiated supplier terms, but each can affect service, margin or relationships.

Positive working capital does not guarantee immediate cash and negative working capital is not always fatal in a fast-cash retail model. Interpret the composition, timing and business model.

Liquidity is the ability to pay short-term obligations from available current assets. The current ratio = current assets ÷ current liabilities; the acid-test ratio = (current assets − inventory) ÷ current liabilities.

The acid test removes stock because stock may take time to sell or may realise less than its recorded value. A current ratio of 3.07:1 and acid test of 1.44:1 tell different stories about a stock-heavy firm’s immediate capacity.

Compare ratios with cash-flow forecasts, credit terms and industry practice. A firm with fast customer payments can operate safely with less liquidity than one whose inventory and receivables turn slowly.

Liquidity is not profit and a ratio threshold is not a universal safety line. Check the quality and timing of current assets, upcoming bills and access to finance.

A cash-flow forecast estimates inflows and outflows over a future period so a business can anticipate shortages, surpluses and finance needs. It is useful because each assumption can be changed and the knock-on effect traced.

Carry the closing balance forward as the next opening balance and recalculate after any change in wages, sales, stock or loan payments. Forecasts can support borrowing and planning, but their reliability depends on research, skill and realistic assumptions.

If a new assistant raises monthly wages by £3,000, total outflows, net cash flow and every later closing balance change. The model exposes when the extra cost becomes affordable rather than hiding it in a single annual profit figure.

A precise-looking table is not accurate evidence by itself. Test sensitivity to external shocks, seasonal sales and payment timing, and distinguish an expected balance from money already in the bank.

Investment is spending on an asset or project expected to create future value; profit records performance over a period, while cash flow records the timing of payments and receipts. They can move in opposite directions during growth.

A new machine may require a large cash payment now but later increase capacity, quality or price. Depreciation spreads its accounting cost across years, so reported profit will not mirror the original cash outflow.

A business that buys equipment before sales rise may show a temporary cash squeeze even if the investment is strategically sound. Compare the forecast, funding terms, expected returns and downside rather than rejecting the investment from one month’s balance.

Investment is not automatically good and profit is not proof that cash is available. State the timing, financing and expected mechanism before judging a project.

Cash-flow strategies aim to bring cash in sooner, delay or reduce outflows, or add finance while protecting the business’s ability to operate. The right choice depends on whether the gap is temporary, structural or caused by weak profitability.

Faster invoicing, tighter credit control, selling excess stock, negotiated supplier terms, an overdraft, new capital or sale-and-leaseback can all change cash timing. Each carries a cost: lost customers, lower margins, interest, dilution or future lease payments.

A seasonal café may use a short overdraft before summer receipts, while a business with persistently negative forecasts needs deeper cost, pricing or business-model changes. Recalculate the forecast after each action.

One cash injection does not cure an unprofitable operation, and delaying suppliers indefinitely can destroy creditworthiness. Explain the mechanism, duration and side effects of the strategy.