Business management | Cash flow

💸 Unit 3.7: Cash Flow – Following the Money Pipeline

Hello future business leaders! Welcome to one of the most practical and crucial topics in finance: Cash Flow.
Don't worry if 'finance and accounts' sometimes feels like a mountain of numbers—we're going to break down cash flow into simple, relatable parts.

You might think that if a business makes a profit, it must be healthy. But in the business world, we have a saying: "Profit is an opinion, but cash is a fact."
Understanding cash flow helps us see if a business actually has the money in the bank *right now* to pay its bills. It's the lifeblood of any organization!

In this chapter, we will learn what cash flow is, why it's different from profit, and how managers use cash flow analysis to keep the business running smoothly and avoid crisis.

💰 1. Defining Cash Flow: Inflows and Outflows

Cash flow simply means the movement of cash (money) both into and out of a business over a period of time.

Think of your business as a bucket. If more water (cash) is pouring in than is leaking out, you have positive cash flow. If more water is leaving than coming in, you have negative cash flow.

Key Definitions:

• Cash Inflows (Money In): Cash received by the business.
  • Examples: Cash sales, payments from customers (debtors), bank loans received, sale of old assets.
• Cash Outflows (Money Out): Cash paid out by the business.
  • Examples: Paying suppliers (creditors), paying wages, rent, purchasing new machinery, repaying loans.

The net result is calculated very simply:

\( \text{Net Cash Flow} = \text{Total Cash Inflows} - \text{Total Cash Outflows} \)

Positive Net Cash Flow is when inflows exceed outflows. This increases the bank balance.
Negative Net Cash Flow is when outflows exceed inflows. This reduces the bank balance.

Key Takeaway: Cash flow focuses only on physical money moving in and out of the bank account, not promises or future payments.

🧐 2. The Critical Difference: Cash Flow vs. Profit

This is the most common point of confusion for students, but it’s essential to master! A business can be profitable but still fail due to a lack of cash.

Profit measures the difference between sales revenue and costs (including non-cash items like depreciation) over a period, based on the principle of matching revenue to expense.

Cash Flow measures the actual movement of money in and out of the business's bank account.

Why are they different? (The Timing Issue)

The key reason profit and cash flow differ is timing. Business accounts often use an accruals basis (recording revenue when it’s earned, not when the cash is received).

• Credit Sales: When a business sells goods on credit, they record the revenue immediately (increasing profit), but the cash inflow only happens weeks or months later when the customer finally pays. This difference creates Trade Receivables (money owed to the business).
• Fixed Asset Purchases: Buying a new machine (a massive cash outflow) is treated as a cost over many years through depreciation when calculating profit. In cash flow, the full cost is recorded immediately.
• Stock Purchases: A business might buy large quantities of inventory and pay cash immediately (huge outflow), but those items might not be sold (and generate revenue/profit) for months.

Example Analogy: Imagine you are paid $1,000 for tutoring, but the client promises to pay you next month. Your Profit statement shows $1,000 earned today. Your Cash Flow statement shows $0 received today. You can't pay your rent with a promise!

Did you know? Many successful, fast-growing start-up businesses go bankrupt not because they aren't profitable, but because they run out of cash paying for expansion before customers pay them. This is often called "overtrading."

Key Takeaway: Profit determines wealth; Cash flow determines solvency (the ability to pay short-term debts). Both are needed for long-term survival.

📊 3. The Cash Flow Statement (HL/SL Focus)

To properly analyze where cash is coming from and where it is going, businesses prepare a Cash Flow Statement. This statement breaks down all cash movements into three major areas of business activity.

The Three Activities of Cash Flow (O-I-F)

It helps to memorize these three categories. They tell the story of how the business manages its core operations, investments, and financing structure.

1. Cash Flow from Operating Activities (CFO)

   This covers the day-to-day running of the business.

   • Inflows: Cash sales, receipts from trade receivables (debtors).
   • Outflows: Payments for inventory, wages, rent, utility bills.

   A healthy business should generally generate a significant positive cash flow from operations.

2. Cash Flow from Investing Activities (CFI)

   This covers the purchase or sale of long-term assets, often called Fixed Assets or Non-current Assets.

   • Inflows: Sale of land, machinery, or buildings.
   • Outflows: Purchase of new machinery, factories, or investments in other companies.

   For growing businesses, this figure is often negative (an outflow) because they are spending cash to buy new equipment for expansion.

3. Cash Flow from Financing Activities (CFF)

   This covers transactions related to debt, equity, and the capital structure of the business.

   • Inflows: Taking out new bank loans, issuing new shares to investors.
   • Outflows: Repaying loan principal, paying dividends to shareholders.

   This section shows how the business funds its operations and growth.

The sum of these three activities gives you the Net Cash Flow for the period.

\( \text{Net Cash Flow} = \text{CFO} + \text{CFI} + \text{CFF} \)

Key Takeaway: Analyzing the O-I-F breakdown reveals where the cash is truly generated and spent. For instance, a positive net cash flow funded only by new loans (Financing) is less sustainable than one funded by robust Sales (Operating).

🔮 4. Cash Flow Forecasting

While the Cash Flow Statement looks backward (what happened last month?), Cash Flow Forecasting looks forward (what we expect to happen next month?).

A cash flow forecast is an estimate of future cash inflows and outflows, usually prepared on a monthly basis, to predict the future cash balance.

How Managers Use Cash Flow Forecasts:

• Identifying Shortfalls: Spotting periods where the cash balance might drop too low (a "cash gap") so that corrective action can be taken *before* bills are due.
• Planning for Surplus: Identifying periods of high cash surplus, allowing managers to plan short-term investments to earn interest rather than letting cash sit idle.
• Supporting Loan Applications: Banks usually require a cash flow forecast to determine if a business will be able to repay a loan.
• Monitoring Performance: Comparing the actual cash flows to the budgeted or forecasted flows to highlight deviations and improve future estimates.

Common Mistakes to Avoid in Forecasting:

Forecasting is tricky because it relies on estimates. The common error is overestimating cash inflows (e.g., assuming debtors will pay on time) and underestimating cash outflows (e.g., forgetting about upcoming maintenance costs).

Don't worry if this seems tricky at first. Remember that forecasting is an estimate, and accuracy improves with experience and good market data.

Key Takeaway: Cash flow forecasting is a proactive management tool essential for preventing liquidity crises.

🛑 5. Causes and Consequences of Cash Flow Problems

A liquidity crisis happens when a business cannot meet its short-term liabilities (bills) because it lacks cash, even if it has strong assets or high profits.

Causes of Cash Flow Problems:

1. Poor Credit Control: Allowing customers too much time to pay, or having many customers who default (don’t pay at all). The money is stuck in trade receivables.
2. Overtrading: Expanding the business too quickly. This requires massive immediate outflows (buying new stock, hiring staff, marketing campaigns) before the related sales revenues are generated and collected.
3. Seasonal Demand: Many businesses (like swimwear retailers or Christmas shops) experience large cash outflows buying stock months before peak sales periods.
4. Unexpected Costs: Unforeseen events, like a sudden legal fee or machinery breakdown, causing massive unplanned outflows.

Consequences of Negative Cash Flow:

• Inability to pay suppliers (damaging reputation and future supply relationships).
• Inability to pay wages (leading to staff leaving or strikes).
• Difficulty repaying loans or paying interest.
• If prolonged, the business faces insolvency (being unable to meet debts) and possible forced liquidation.

🛠️ 6. Strategies to Improve Cash Flow

Managers use several short-term strategies to tackle cash shortages, focusing on either speeding up inflows or delaying outflows.

Strategies to Increase Cash Inflows:

• Tighten Credit Control: Encourage customers to pay faster, perhaps by offering a cash discount for early payment (e.g., 2% off if paid within 10 days).
• Improve Stock Management: Selling off old or slow-moving inventory (even at a discount) converts idle assets into cash.
• Debt Factoring: Selling trade receivables (invoices) to a specialized finance company (a factor) immediately for cash, often at a discount. This gets cash in quickly but reduces the total amount received.
• Short-term borrowing: Using an overdraft (allowing the bank account to go negative up to an agreed limit) or securing short-term loans.

Strategies to Reduce Cash Outflows:

• Delay Payments to Suppliers (Trade Payables): Negotiate longer credit terms with suppliers. *Caution: This must be done carefully to maintain good relationships.*
• Leasing Assets: Instead of paying a large lump sum cash outflow to buy equipment, rent it through a lease agreement, converting a large outflow into smaller, manageable payments.
• Reduce Expenses: Cut non-essential spending, such as delaying non-critical maintenance or freezing staff hiring.