Why a business needs cash
Definition
Cash: the money a business has available immediately, in its till and its bank account, to spend today.
Cash flow: the movement of money into and out of a business over a period of time.
- Cash is what actually settles the bills that arrive on fixed dates: wages every week or month, supplier invoices within 30 days, rent on the quarter day, energy bills, VAT and loan instalments.
- None of those people can be paid with future profit, because a supplier wants money in its account rather than a promise about the year end.
- Cash flows in from sales, from customers settling invoices and from finance received, and flows out to stock, wages, overheads and repayments, so the business survives only if the timing of the two lines up.
Example
- A Nando's restaurant takes cash and card payments the same day it serves customers, so money comes in before most of its bills go out.
- A shopfitting firm buys materials and pays fitters for six weeks before the customer is invoiced, so money goes out long before any comes in.
- The second business needs a far bigger cash cushion than the first, even if both are equally profitable.
The difference between cash and profit
- Profit measures what is left from revenue once total costs are taken off across a whole period, and it counts a sale from the moment it is made. Cash counts only money that has actually arrived, on the day it arrives.
Example
- Brookvale Signs Ltd in Coventry invoiced £48,000 of work during March.
- £26,000 of that was paid on the day, and £22,000 went to business customers on 60-day terms.
- Its total costs of £41,000 were all paid in cash during the month.
Working out Brookvale's profit and its cash flow
| Brookvale Signs, March | Counted for profit £ | Counted as cash £ |
|---|---|---|
| Sales paid on the day | 26,000 | 26,000 |
| Sales on 60-day credit | 22,000 | 0 |
| Revenue, or cash in | 48,000 | 26,000 |
| Costs, all paid in cash | 41,000 | 41,000 |
| Result for March | 7,000 profit | -15,000 net cash flow |
- Read across the two columns and only one row differs: the £22,000 of credit sales counts in full for profit and counts as nothing for cash, and that single row is the whole gap between the two results.
Example
profit=revenue−total costs
\text{profit} = \text{revenue} - \text{total costs}
profit=revenue−total costs
profit=£48,000−£41,000=£7,000
\text{profit} = \pounds48{,}000 - \pounds41{,}000 = \pounds7{,}000
profit=£48,000−£41,000=£7,000
- On paper March was a good month, because Brookvale earned £7,000 more than it spent and its owner can reasonably call the firm profitable.
- In cash terms March was a bad month, because £15,000 more left the bank than entered it.
- The £22,000 owed by credit customers is counted in the profit figure but will not arrive until May, so unless Brookvale had that £15,000 sitting in the bank already it cannot pay April's wages, even though it is trading profitably.
Key Idea
A profitable business can still run out of cash, because cash arrives when customers choose to pay while bills fall due on dates the business cannot move.
Consequences of cash flow problems
- Suppliers go unpaid, so deliveries stop, and a supplier that loses confidence withdraws trade credit and demands cash up front, which makes the shortage worse just when the business can least afford it.
- Wages are paid late or not at all, so skilled staff leave for employers who pay on time and the business cannot serve its remaining customers properly.
- Rent, energy bills and loan instalments are missed, so the landlord can end the lease and the bank can call in its loan and take the assets held as security.
- A business that cannot pay its debts as they fall due is insolvent, and creditors can force it to close. This can happen to a firm whose order book is full and whose profit figure is healthy, which is why running out of cash is one of the commonest reasons new businesses fail.
Common Mistake
- Do not treat a cash flow problem as evidence that the business is unprofitable, because the two are separate diagnoses.
- If a case describes a firm with rising sales that cannot pay a bill, the problem is the timing of its cash, not the strength of its trading.
The effect of positive cash flow
- Positive cash flow means more cash comes in over a period than goes out, so the business ends it with more money in the bank than it started with.
- Every bill is settled on time, which keeps suppliers willing to deliver and often earns longer credit terms or an early-payment discount.
- A cash cushion absorbs shocks such as a broken-down oven or a quiet fortnight, so one bad event does not threaten the whole business.
- Spare cash lets the owner act on opportunities, such as buying a competitor's stock cheaply or taking a bulk discount, and it reduces how much has to be borrowed, which cuts interest costs.
Note
Holding a very large amount of idle cash has its own cost, because that money is earning nothing while it sits in the account instead of buying stock or equipment.
How and why cash flow forecasts are constructed
- A cash flow forecast is a prediction of the cash expected to flow in and out over a future period, set out month by month so the owner can see the bank balance at the end of each month before it happens.
- It is built from evidence rather than guesswork: last year's sales for the same months, the orders already placed, the credit terms customers actually keep to, and bills the business already knows about such as rent, wages and an insurance renewal.
- The main reason for making one is warning, because seeing a shortage three months out gives the owner time to arrange an overdraft, chase debtors or delay a purchase, while discovering it on the day leaves no options.
- A bank will normally insist on seeing a forecast before granting a loan or an overdraft, because it shows whether the business can afford the repayments, and a start-up needs one to judge how much capital it must raise before opening.
- Once the months have passed the forecast becomes a target to check against, so the owner can see which estimates were wrong and correct the next one.
Note
Completing and interpreting the figures inside a forecast, including net cash flow and the opening and closing balance, is covered in the next article.
Self review
- In one sentence, what is the difference between cash and profit?
- Using the table, which row is the reason Brookvale's profit and its cash flow point in opposite directions?
- What does insolvent mean?
- Give two consequences of cash flow problems and two effects of positive cash flow.
- Give two reasons a business constructs a cash flow forecast.
