Business Survival and Cash Flow
Profit and Cash Flow Are Different
Cash flow: the money coming into and going out of a business over a period of time. Money coming in is a cash inflow; money going out is a cash outflow.
Profit is revenue minus costs over a period (see unit 1.6.3). A sale counts towards profit when it is made, but it only counts as cash when the customer actually pays. That timing gap is why a firm's profit and its bank balance can tell very different stories.
The two come apart for several reasons:
- Selling on credit. Many businesses give their customers 30 or 60 days to pay. The sale adds to profit straight away, but the cash arrives weeks later.
- Buying stock in advance. A shop may pay for its Christmas stock in October. The cash leaves months before the goods are sold.
- Buying equipment. A new van is paid for in one go, but its cost is spread over the years it is used, so only part of it comes off this year's profit.
- Loans and owner's capital. Money borrowed from a bank or put in by the owner is a cash inflow, but it is not revenue, so it adds nothing to profit. Repaying a loan is a cash outflow, though only the interest is a cost.
So a profitable business can run short of cash, and a loss-making business can have plenty of cash for a while, for example just after taking out a loan.
Why Cash Flow Matters for Survival
A business pays its staff, suppliers, landlord and lender in cash, not in profit. Cash runs out → it cannot pay its bills when they are due, so it is insolvent → suppliers stop delivering and the people it owes take it to court → the business can be forced to close even if its products sell well.
New and fast-growing firms are most at risk. A new business has to pay set-up costs before any sales come in. A growing one wins more orders → buys more stock and takes on more staff before the extra customers pay → cash goes out faster than it comes in. The faster it grows, the more cash it needs. This is sometimes called overtrading.
Late payment makes this worse. A small firm selling to a large one may wait weeks beyond the agreed date to be paid. UK law lets a business claim interest on a late payment from another business at 8% above the Bank of England base rate.
Forecasting and Interpreting Cash Flow
Cash-flow forecast: an estimate of a business's cash inflows and outflows, month by month, for the months ahead. It shows when the business is likely to have spare cash and when it is likely to run short.
A forecast has the same rows every month:
- Inflows, such as cash sales, payments from credit customers, loans and money put in by the owner.
- Outflows, such as stock and materials, wages, rent, bills, loan repayments and equipment.
- Net cash flow, which is inflows minus outflows for that month.
- Opening balance, the cash the business has at the start of the month. It is always the closing balance of the month before.
- Closing balance, which is the opening balance plus net cash flow.
Worked Example: Rosa's Christmas Rush
Rosa sells scented candles, and most of her year's sales come before Christmas. She has £1,500 in the bank at the start of October. She buys most of her wax and jars in October to be ready for the rush, and her fixed costs are £2,000 a month. All her customers pay straight away.
| October | November | December | |
|---|---|---|---|
| Sales (inflow) | £3,600 | £8,400 | £12,000 |
| Materials | £6,000 | £1,200 | £800 |
| Fixed costs | £2,000 | £2,000 | £2,000 |
| Total outflows | £8,000 | £3,200 | £2,800 |
| Net cash flow | (£4,400) | £5,200 | £9,200 |
| Opening balance | £1,500 | (£2,900) | £2,300 |
| Closing balance | (£2,900) | £2,300 | £11,500 |
Figures in brackets are negative. Over the three months Rosa takes £24,000 and spends £14,000, so the quarter is profitable: her bank balance ends £10,000 higher than it started. But in October she spends £8,000 and takes only £3,600, and her balance falls to minus £2,900. Without arranging credit first, she could not pay her bills that month, even though the run-up to Christmas will be her best season.
When you interpret a forecast, look for the months where the closing balance goes negative, how far it falls and how long it stays there. Then look for the cause: a seasonal dip in sales, a large one-off purchase, or customers paying late. A short dip with a clear reason, like Rosa's, is much less worrying than a balance that falls month after month.
Don't confuse net cash flow with the closing balance. Net cash flow is what happened in one month; the closing balance is how much cash the business has left. A month can have negative net cash flow and still end with money in the bank if the opening balance was big enough. It is the closing balance that shows whether the business needs to borrow.
Using a Forecast to Plan Credit and Reduce Risk
A forecast shows a business when it will need credit and how much. Rosa needs to borrow at least £2,900 for October and can repay it in November. An overdraft (see unit 1.4.3) suits this, as she pays interest only on what she uses, and a limit a little above £2,900 allows for weaker sales.
Arranging credit in advance is cheaper and easier than asking for it in a crisis. A bank is more willing to lend to a business that can show it saw the shortfall coming and knows how it will repay.
A forecast also gives a business time to act before the cash runs out. It can:
- chase customers who owe it money, or offer less time to pay
- ask suppliers for longer to pay (trade credit)
- delay buying equipment, or lease it instead of buying it
- spread large purchases over several months
A forecast is only an estimate: sales may be lower than expected, or a customer may pay late. Firms reduce the risk by updating it each month and asking "what if?", such as what happens if sales are 20% lower.
Stuck on this topic? Work through it with an online A-Level Economics tutor in a free 15-minute intro call, or send an essay on it for A-Level Economics essay marking.