The importance of cash to a business
Cash is the money a business has available right now — in the bank or in the till. The specification gives two reasons it matters and one distinction that carries most of the marks.
To pay suppliers, overheads and employees. These have to be paid on time, in money, whatever the state of the order book. Suppliers stop delivering if they are not paid, and staff leave if wages are late.
To prevent business failure. A business that cannot pay its bills when they fall due is insolvent, and it can be forced to close even if it is making a profit on paper. Running out of cash is one of the most common reasons new businesses fail.
The difference between cash and profit is the idea this sub-topic is really testing.
Profit is revenue minus costs over a period of time. Cash is the money actually available at a moment in time. They differ because money is often received or paid at a different time from when the sale or cost is recorded:
• A business sells goods on credit — the sale counts towards profit immediately, but the cash arrives 30 or 60 days later. • A business buys stock — the cash leaves now, but the cost only counts against profit when the stock is sold. • A business buys equipment — a large cash outflow at once, spread across several years in the accounts.
So a profitable business can run out of cash, and a business with plenty of cash can be making a loss.
Common mistake
Profitable is not the same as solvent. A business making a healthy profit can still fail if the cash arrives too late to pay this month's wages — which is exactly why cash-flow forecasts exist.
- Cash
- the money a business has available right now, in the bank or in the till; a business can be profitable and still fail if it runs out of cash
Cash-flow forecasts
A cash-flow forecast predicts the money flowing into and out of a business over the coming months, so problems can be seen before they arrive.
The four terms to know:
• Cash inflows — money coming in: sales revenue, loans received, money invested by the owner. • Cash outflows — money going out: paying suppliers, rent, wages, equipment, loan repayments. • Net cash flow — total inflows minus total outflows for that month. It can be negative. • Opening and closing balance — the cash held at the start and end of the month.
Two relationships link them, and both are needed:
net cash flow = total inflows − total outflows closing balance = opening balance + net cash flow
And the one that makes the table work: this month's closing balance becomes next month's opening balance.
Worked example
In April, inflows are £9400 and outflows are £10 100. The opening balance is £2000. Calculate the net cash flow and the closing balance, and say what the business should do.
- Net cash flow = inflows − outflows = 9400 − 10 100 = −£700.
- Closing balance = opening balance + net cash flow = 2000 + (−700).
- = £1300.
- Interpret it: the balance is still positive, so the business can pay its bills this month.
- But the trend is the warning — a negative net cash flow repeated for two more months would push the balance below zero.
Answer: Net cash flow is −£700 and the closing balance is £1300. The business is still solvent, but it is spending more than it receives, so it should act now — before the balance runs out — by chasing customer payments, delaying non-urgent spending, or arranging an overdraft.
How to improve cash flow, which follow-up questions usually ask for:
Increase inflows — chase customers who owe money, offer discounts for early payment, sell unused assets, arrange a loan or overdraft, or ask the owner to invest more.
Reduce or delay outflows — negotiate longer credit terms with suppliers, lease equipment instead of buying it, cut non-essential spending, or reduce stock levels so less money is tied up.
Each has a drawback worth mentioning in an evaluation: discounts for early payment reduce revenue, an overdraft costs interest, and delaying supplier payments can damage the relationship.
Why a business produces a forecast at all: to spot a shortfall early enough to arrange finance, to support a loan application or business plan, and to plan the timing of big purchases. Its limitation is that it is only a prediction — based on estimated sales that may not happen, and on costs that may rise unexpectedly.
- Cash-flow forecast
- a prediction of the money flowing into and out of a business over the coming months, so problems can be seen before they arrive
- Cash inflows
- money coming into the business: sales revenue, loans received, money invested by the owner
- Cash outflows
- money going out of the business: payments to suppliers, wages, rent and other costs
- Net cash flow
- cash inflows minus cash outflows over a period
Before you practise
- Cash is needed to pay suppliers, overheads and employees, and to prevent insolvency.
- Profit is revenue minus costs over a period; cash is money available at a moment.
- They differ because of credit sales, buying stock and buying equipment — so a profitable business can still run out of cash.
- net cash flow = total inflows − total outflows.
- closing balance = opening balance + net cash flow.
- This month's closing balance is next month's opening balance.
- Improve cash flow by increasing or speeding up inflows, and reducing or delaying outflows — each with a drawback.
- A forecast is a prediction, so it is only as good as the estimates behind it.