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.
Cash Flow Forecasts
- 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.
- Construction of a cash flow forecastA 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.
The relationship between investment, profit and 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.
Strategies for Dealing with Cash Flow Problems
- 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.
