3.7: Profit vs Cash Flow

Difference between profit and cash flow

Cash Flow and Profit
Cash is essential for a business's operation, as it's needed for daily expenses like wages and electricity. Failure to pay creditors can lead to bankruptcy. Cash is a current asset and can be held in hand or at the bank.
Profit is the difference between total revenue and total costs. When a sale exceeds production costs, it contributes to profit. A business reaches its break-even point when sales cover all costs.
Credit Sales and Cash Flow:
Credit Sales: Customers can buy now and pay later. This can attract customers but also cause cash flow problems.
Profit vs. Cash: Profit is made when sales exceed costs, but cash isn't always received immediately with credit sales.
Cash Deficiency and Unprofitability:
Cash Deficiency: Can be caused by poor credit control, rapid expansion, or seasonal demand fluctuations.
Unprofitability: Even with high cash flow, a business can be unprofitable if it doesn't manage costs effectively.
Conclusion:
A business needs both profitability and cash flow management to survive. While profit indicates overall financial health, cash flow ensures the business can meet its day-to-day obligations.

A cash flow forecast is a financial tool that predicts the movement of cash into and out of a business. It's based on:
Cash inflows: Money coming into the business (sales revenue, debtor payments, loans, interest, asset sales, rental income).
Cash outflows: Money leaving the business (invoices, bills, rent, wages, inventory, taxes, creditor payments, advertising, loans, dividends).
Net cash flow: The difference between inflows and outflows. Ideally, it should be positive.
Importance of Cash Flow Forecasts:
Financial Health Assessment: Helps banks and lenders assess a business's financial health.
Liquidity Problem Anticipation: Identifies potential cash shortages.
Business Planning: Facilitates better planning and financial control.

The balance sheet is a financial statement that shows a company's assets, liabilities, and equity on a specific date. It's like a snapshot of the company's financial health.
Key components:
Assets: Items of value owned by the company (e.g., cash, property, equipment).
Noncurrent assets: Used for operations, last more than 12 months.
Current assets: Easily converted to cash within 12 months (e.g., cash, debtors, inventory).
Liabilities: Debts owed by the company (e.g., bank overdrafts, trade creditors, loans).
Noncurrent liabilities: Due after 12 months (e.g., mortgages).
Current liabilities: Due within 12 months.
Equity: The owners' stake in the company (e.g., share capital, retained earnings).
Relationship:
Net assets = Total assets - Total liabilities.
Net assets must equal total equity.
Limitations:
Static view: Shows a snapshot of financial position on a specific date.
Estimated values: Asset values can be subjective.
Incomplete information: Intangible assets and human capital may not be included.
Lack of standardization: Different formats can make comparisons difficult.
Overall, the balance sheet provides a valuable overview of a company's financial health, but it's important to consider its limitations when interpreting the information.

A cash flow forecast includes:
Opening balance: The starting cash balance.
Cash inflows: Revenue from sales and other sources.
Cash outflows: Expenses like stock purchases, labor, and other costs.
Net cash flow: The difference between inflows and outflows.
Closing balance: The ending cash balance, calculated as opening balance + net cash flow.

Cash vs. Profit
Cash and Profit aren't the same: A business can be profitable but lack cash flow, or cash-rich but unprofitable.
Example: Franchise: A new franchise might have strong cash flow but be unprofitable due to high initial investment costs.
Investment and Cash Flow
Investment: Spending on capital assets to generate future cash flows and profits.
Short-term Impact: Investment can reduce cash flow in the short term but improve profits in the long run.
Example: Lenovo: Lenovo's acquisition of Motorola reduced cash flow but aimed to increase future profits.
Financing Investment
Diversified Companies: Can rely on alternative revenue streams to improve cash flow.
Example: Microsoft and Facebook: These companies used their strong cash positions to acquire other businesses.
Cash Flow Management and Investment
Importance of Cash Flow: Good cash flow management is crucial for investment opportunities.
Example: Pharmaceutical Industry: Requires effective cash flow and product portfolio management for long-term success.

Causes of Cash Flow Problems:
Overtrading: Expanding too quickly without sufficient resources.
Over Borrowing: High interest payments on external financing.
Overstocking: Excess inventory tied up in stock.
Poor Credit Control: Difficulty collecting payments from debtors.
Unforeseen Changes: Unexpected events like machinery breakdown or seasonal demand fluctuations.
Strategies to Address Cash Flow Problems:
Reducing Cash Outflows:
Negotiate better credit terms.
Seek alternative suppliers.
Improve stock control.
Lease assets instead of buying.
Reduce unnecessary expenses.
Improving Cash Inflows:
Tighter credit control.
Offer incentives for early payments.
Expand product portfolio.
Obtaining Additional Finance:
Overdrafts.
Selling fixed assets.
Debt factoring.
Government assistance.
Challenges and Limitations of Cash Flow Forecasting:
Inaccurate Assumptions: Factors like market research, workforce morale, operational issues, competitor behavior, economic changes, and external shocks can affect cash flow forecasts.
Limited Time Horizon: Cash flow forecasts are typically for the short term due to the difficulty of predicting the future.
Continuous Monitoring: Regular adjustments and monitoring are necessary for effective cash flow management.