Cash Flow & Financial Statements

Cash and profit are not the same thing

One of the most common mistakes in business is to assume that a profitable business cannot run out of money. In fact, plenty of profitable firms collapse because they run out of cash. Understanding the difference between cash and profit is the foundation of this whole chapter.

Profit is what is left over when total costs are taken away from total revenue over a period of time. Cash is the actual money a business has available right now to pay its bills. A sale made on credit counts towards profit immediately, but no cash arrives until the customer actually pays — which might be 30, 60 or even 90 days later.

Key terms Cash — the notes, coins and money in the bank account that a business can spend immediately.

Profit — total revenue minus total costs over a period of time.

Liquidity — how easily a business can turn its assets into cash to pay short-term debts.

Watch out Cash and profit are tested almost every year, and students lose marks by treating them as the same. A business can be profitable but have no cash (because customers owe it money, or it has spent cash on stock and machinery). It can also have cash but make a loss (for example after taking out a loan). Always read the question carefully to see whether it is asking about cash flow or profit.

Why cash flow matters

Cash flow is the movement of money into and out of a business over time. Without enough cash, a business cannot pay wages, suppliers, rent or loan repayments — and if it cannot pay these, it may be forced to stop trading even when its order book is full.

Common causes of cash-flow problems include:

Allowing customers too much credit — selling now but being paid much later.
Holding too much stock — cash is tied up in unsold goods.
Overtrading — expanding too quickly and spending cash on stock, staff and equipment faster than money comes in.
Poor planning — not forecasting when large outflows (such as tax or a loan repayment) will fall due.
Seasonal demand — a low-sales month with the same fixed costs as a busy month.
Unexpected costs — a machine breaking down or a customer failing to pay (a bad debt).

Cash-flow forecasts

A cash-flow forecast is a prediction of the cash that will flow into and out of a business in each future period (usually each month). It helps a business spot future shortages early, so it can arrange an overdraft or cut spending before a crisis hits. Banks also often demand one before lending.

The key terms you must be able to use are:

Cash inflows — money coming in (mainly from sales, but also loans or owner's capital).
Cash outflows — money going out (wages, stock, rent, utilities and so on).
Net cash flow — inflows minus outflows for the period: $\text{Net cash flow} = \text{Inflows} - \text{Outflows}$. It can be positive or negative.
Opening balance — the cash held at the start of the month. This is the same as the previous month's closing balance.
Closing balance — the cash held at the end of the month: $\text{Closing balance} = \text{Opening balance} + \text{Net cash flow}$.

Worked example A small café forecasts the following for three months. Complete the blanks.

Inflows are £6,000 (Jan), £7,000 (Feb) and £9,000 (Mar). Outflows are £8,000 (Jan), £6,500 (Feb) and £7,000 (Mar). The opening balance in January is £1,000.

January: net cash flow $= 6{,}000 - 8{,}000 = -£2{,}000$. Closing $= 1{,}000 + (-2{,}000) = -£1{,}000$.

Here is that forecast laid out as a table — exactly how it appears in the exam:

The negative closing balances in January and February warn the owner of a cash shortage. They could arrange a short overdraft to cover it, knowing March recovers.

Exam tip When completing a forecast, always work top to bottom in each column, then carry the closing balance across to become the next month's opening balance. Show a negative figure clearly with a minus sign or brackets — examiners reward correct use of negative numbers.

Ways to improve cash flow

If a forecast shows a shortage, a business can act. Methods include:

Arrange an overdraft or short-term loan to cover a temporary gap.
Reduce credit given to customers so cash comes in faster.
Negotiate longer credit from suppliers so cash goes out later.
Sell off excess stock to release tied-up cash.
Sell or lease unused assets rather than buying them outright (sale and leaseback).
Delay or spread out spending on new equipment.

Real world Many large supermarkets enjoy strong cash flow because customers pay instantly (cash or card) while the supermarket pays its suppliers weeks later. The gap means cash sits in the business in the meantime — a built-in cash-flow advantage.

Each method has a drawback: overdrafts charge interest, cutting customer credit may lose sales, and pushing suppliers too hard can damage relationships. A good answer weighs these up.

The income statement

The income statement (sometimes called the profit and loss account) shows how much profit or loss a business made over a period. You should know its basic structure:

1. Revenue — total income from selling goods or services.
2. Cost of sales — the direct cost of the goods that were sold.
3. Gross profit $= \text{Revenue} - \text{Cost of sales}$.
4. Expenses — running costs such as rent, wages and marketing (also called overheads).
5. Net profit $= \text{Gross profit} - \text{Expenses}$.

Key terms Gross profit — profit after deducting only the direct cost of goods sold.

Net profit — profit after deducting all costs and expenses; the true bottom-line profit.

The statement of financial position

The statement of financial position (or balance sheet) is a snapshot of what a business owns and owes on one particular day.

Assets — things the business owns that have value. Non-current (fixed) assets such as machinery and buildings are kept long-term; current assets such as cash, stock and money owed by customers can be turned into cash within a year.
Liabilities — what the business owes. Current liabilities (such as an overdraft) are due within a year; non-current liabilities (such as a long-term bank loan) are due later.

At IGCSE you only need to identify these items and understand that assets show what the business controls while liabilities show what it must repay.

Profitability ratios

Ratios let us judge how well a business turns sales into profit. The two you need are profit margins, both shown as percentages:

$$\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100$$

$$\text{Net profit margin} = \frac{\text{Net profit}}{\text{Revenue}} \times 100$$

A higher margin is better. Comparing the two reveals whether expenses are eating into profit.

Worked example A firm has revenue of £200,000, cost of sales of £120,000 and expenses of £40,000.

Gross profit $= 200{,}000 - 120{,}000 = £80{,}000$.

Gross profit margin $= \dfrac{80{,}000}{200{,}000} \times 100 = 40\%$.

Exam tip Always multiply by 100 to give a percentage, and keep revenue on the bottom of the fraction. To improve a gross margin, a firm can raise prices or cut cost of sales; to improve a net margin, it must control expenses too.