Cash Flow & Working Capital (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
The Difference Between Profit & Cash Flow
Profit and cash are different financial terminologies
Profit is calculated at a specific point in time
While a company may be in profit, they may lack cash as some customers may not actually have paid them yet
Profit is the difference between revenue generated and total business costs during a specific period of time
Profit can be an important indicator of a company's financial health and long-term sustainability as it helps to assess the effectiveness of a company's operations
Cash is measured by taking into account the full range of money flowing in and out of a business
This includes revenue from sales, operating expenses, investments, loans, and any other cash-related transactions
A profitable business is likely to fail if it does not have sufficient cash
Cash-poor businesses will struggle to pay suppliers
E.g. Lifestyle retailer Joules announced plans to liquidate in December 2022 as a result of cash flow difficulties despite making a profit of £2.6 million during the previous year
Working Capital
Working capital is the money that a business has available to fund its day to day activities
It is sometime included as net current assets on the Statement of Financial Position
Working capital is calculated using the formula
Working capital = Current assets - Current liabilities
Worked Example
Rondat Components is a heating components business based in Malmö. It has been struggling to control its level of stock. Its customers are Scandinavia’s leading gas boiler manufacturers,. They require Rondat Components to supply products ‘just in time’ and as a result they must hold large amounts of varied stock to ensure that their customer’s needs can be met. Rondat Components offers its customers 90-days credit terms.
Financial Information for Rondat Components
| 2022 £m | 2021 £m |
Stock | 8.1 | 7.2 |
Debtors | 2.2 | 3.1 |
Cash | 0.9 | 1.2 |
Short-term loan | 6.4 | 4.4 |
Creditors | 5.1 | 5.9 |
Calculate Rondat Components’ working capital in 2021 and 2022 [3]
Answer:
Step 1: Identify and calculate current assets and current liabilities for 2022 and 2021
Current assets [1 mark]
Current liabilities [1 mark]
Step 2: Subtract current liabilities from current assets for 2022 and 2021
[1 mark]
Managing working capital
Working capital is described as the lifeblood of a business because a lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations
Cash is the most liquid of a business's current assets and can be used to settle debts immediately
Effective management of working capital involves careful cash management
Debtors and stock are less liquid
Businesses that are struggling with a lack of working capital may look to convert these current assets into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully chasing payment from customers)
Requesting an extension of payment terms from suppliers can increase working capital in the short term as cash remains in the business for longer
Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation as it can access more cash than it has in its current account
A business can have too much working capital
If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments
This may represent a significant opportunity cost especially when interest rates are high
If a business is holding large amounts of stock it may incur extra storage costs (e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for other purposes
Examiner Tip
A common exam error is the confusion between working capital and cash. Whilst working capital includes cash, it also includes less liquid current assets (e.g. debtors and stock). These less liquid assets cannot be used to pay bills and so, whilst a business may have a positive working capital figure, it may still fail because it cannot meet its immediate financial commitments.
Liquidity Position
The Statement of Financial Position contains the financial information required to draw conclusions about the liquidity of the business
Liquidity is the ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets
A business that cannot pay its bills will usually fail very quickly, even if they are profitable
Managing liquidity is a key way to manage risk in a business - and helps a business to prepare for the unexpected
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