The Importance of Cash Flow (AQA GCSE Business)

Revision Note

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Cash Versus Profit

  • Profit and cash are different financial terminologies

    • 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 success, 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

  • While a company may make a profit, they may lack cash as some customers may not actually have paid them yet

Diagram: profit vs cash flow

Profit and Cash are different concepts in business. A business may make a profit yet lack cash.

Profit and Cash-flow are two distinct terms. A business that does not make a profit in the long run will cease to trade

  • Cash performs a variety of functions in a business

    • It is used to cover regular operating expenses such as workers' pay, supplier invoices and overheads such as rent and utility bills

    • It can also be used to meet unexpected expenses, such as the replacement of broken equipment

  • A profitable business is likely to fail quickly if it does not have sufficient cash

    • Cash-poor businesses will struggle to pay suppliers, employees and operating expenses

    • This is called insolvency 

      • 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

Why Cash Flow is Important

  • Cash is the 'blood' of a business, as without it, a business cannot survive

    • It is a liquid asset in the form of notes, coins and money in the bank

  • A new business may have to pay cash on purchase for all of its supplies until its suppliers trust them enough to provide credit terms (buy now, pay later)

    • A supplier may then give the business trade credit of 30 or 60 days

    • This means that the business can receive their stock now and only pay for it in 30 or 60 days; the cash outflow is delayed

    • As the business sells its products, they receive money generated from the business revenue, which represents a cash inflow

    • At the end of 60 days, they will pay their supplier (cash outflow), but the firm may still have half of its stock available for sale

  • More established businesses need to ensure that they manage cash-flow to ensure that they do not run out of money

    • Cash-flow issues may put the business in a situation where it is 

      • Unable to pay key stakeholders, such as workers and suppliers

        • Production is likely to cease as workers will not work without pay and suppliers will not supply goods if they are not paid

        • Unable to pay utility bills and rent

      • The business could be forced into liquidation and, ultimately, is likely to fail

Examiner Tip

A common misconception is that cash flow is the same as working capital. Working capital represents the amount of money a company has to pay its short-term obligations. Cash flow is the net amount of cash and cash equivalents coming in and out of a company and is represented on the cash flow statement.

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