Cash flow and profit are both essential to business success, but they represent different aspects of financial performance and require careful and continuous management.
What is Cash Flow?
Cash flow refers to the total movement of money into and out of a business over a defined period, such as a month, quarter, or financial year. Unlike profit, which can include non-cash items and be influenced by accounting methods, cash flow is concerned only with actual cash transactions — that is, money physically entering or leaving the business’s accounts.
There are three main types of cash flows businesses monitor:
Operating cash flow: cash generated from day-to-day activities, including cash received from customers and payments made to suppliers, employees, and for other operating expenses.
Investing cash flow: cash used for or generated by investment activities, such as buying or selling equipment, property, or financial investments.
Financing cash flow: cash exchanged with creditors and investors, such as loan repayments, issuing shares, or paying dividends.
Importance of Managing Cash Flow
Effective cash flow management is critical because:
It ensures liquidity: A business must have sufficient cash on hand to pay suppliers, employees, taxes, and other obligations when they are due.
It supports operational continuity: Even profitable businesses can be forced to halt operations or go bankrupt if they run out of cash.
It enables strategic decision-making: Businesses with healthy cash flow can take advantage of investment opportunities, weather financial downturns, and improve their negotiating position with stakeholders.
It builds trust with investors and lenders: Strong and predictable cash flow is often seen as a signal of good financial health and management.
What is Profit?
Profit, also known as net income or net earnings, is the amount of money a business retains after deducting all of its costs from its total revenue. It reflects how effectively a business converts its sales into financial gain over a period of time.
There are three key levels of profit to understand:
Gross profit: Revenue minus the cost of goods sold (COGS). This shows how efficiently a business produces or sources its products.
Operating profit: Gross profit minus operating expenses (e.g. salaries, rent, marketing). This reveals the profitability from core operations before interest and tax.
Profit for the year (also known as net profit): Operating profit minus interest and tax expenses. This represents the final bottom-line figure available to owners or shareholders.
Profit is recorded on the income statement (also called the profit and loss account), and does not necessarily reflect the actual flow of cash in and out of the business.
Why Profit Is Important
Indicates financial success: A key indicator of whether a business model is viable and generating value.
Attracts investment: Investors and lenders are more likely to back profitable businesses.
Supports growth: Profits can be reinvested to finance expansion, improve products, or enter new markets.
Drives strategic planning: Profitability guides pricing, budgeting, and resource allocation decisions.
Key Differences Between Cash Flow and Profit
Although both concepts relate to the financial performance of a business, cash flow and profit are fundamentally different:
Cash flow tracks when money actually enters or exits the business, regardless of when revenue or expenses are recognised.
Profit measures the difference between revenue and expenses, and follows the rules of accrual accounting.
Key distinctions:
Timing: Cash flow looks at real-time movement of money. Profit is based on the timing of revenue recognition and expense matching.
Scope: Cash flow includes transactions like loan repayments or new financing which are not reflected in profit.
Purpose: Cash flow is used to assess liquidity. Profit is used to assess long-term viability and financial performance.
Reporting: Cash flow is reported in the cash flow statement; profit is reported in the income statement.
Timing Differences and Their Consequences
One of the main reasons for confusion between cash flow and profit is timing. Revenue and expenses may be recorded in one accounting period but the actual cash movement might occur in a different period.
Revenue Recognition vs Cash Receipt
A business might make a sale in one month but not receive payment until the next. This creates a difference between recorded profit and actual cash inflow.
Example:
A firm sells goods worth £10,000 in January with payment due in 30 days.
It records the sale as revenue in January (increasing profit).
However, the cash is received in February (affecting cash flow then).
This means that in January:
Profit increases by £10,000.
Cash flow does not increase.
The business still needs cash in January to pay suppliers and staff.
Accruals and Prepayments
Expenses are often recorded when incurred rather than when paid. This can misalign profit with actual cash usage.
Example:
An insurance premium of £12,000 is paid in January for 12 months’ cover.
In the income statement, only £1,000 is expensed each month (to match usage).
In the cash flow statement, the full £12,000 is recorded as an outflow in January.
Inventory and Depreciation
Inventory purchases consume cash when paid but don’t affect profit until the goods are sold.
Depreciation reduces profit (as a non-cash expense) but has no impact on cash flow.
These examples show why timing matters, and how profit and cash flow can diverge significantly in practice.
Can a Profitable Business Run Out of Cash?
Yes — this is a common situation and a serious risk, especially for growing businesses. A business may report high profits but still run out of cash due to poor working capital management or bad timing.
Scenarios where this can occur:
1. Slow-paying customers
Credit sales create receivables (money owed).
If customers delay payment, the business has recorded revenue (and profit) but has not received the cash.
Bills, salaries, and loan repayments still need to be paid, using available cash.
2. Excessive inventory
Cash is used to purchase stock.
Until the stock is sold, the money is tied up and unavailable for other uses.
Excess inventory increases costs and reduces cash reserves.
3. Rapid growth (Overtrading)
A business increases sales and production quickly.
More cash is needed to fund new staff, stock, and facilities.
Without a matching increase in cash inflow, liquidity problems emerge.
4. Large capital investments
Buying equipment or property uses large amounts of cash upfront.
These assets are capitalised and depreciated over time (affecting profit gradually).
But the cash is gone immediately.
5. Loan repayments
Interest expenses appear in profit calculations.
However, capital repayments on loans affect cash flow only and not profit.
These repayments can drain cash reserves.
6. Dividend payments
A business might pay dividends based on last year’s profit.
This reduces current cash, even if current profit is low or negative.
In all these cases, profitability does not guarantee sufficient liquidity. This is why cash flow forecasting and control is essential for all businesses, especially those with seasonal sales or long customer credit periods.
Monitoring and Improving Cash Flow and Profit
Businesses must manage and track both cash flow and profit through systematic methods and tools.
Tools for Monitoring Cash Flow
1. Cash Flow Forecast
A projection of expected cash inflows and outflows over a future period (e.g. monthly).
Identifies potential cash shortages.
Helps plan borrowing or investment needs.
Supports budget setting.
2. Cash Flow Statement
A retrospective report that records actual cash movement in three categories:
Operating activities
Investing activities
Financing activities
Used by internal managers and external stakeholders (e.g. investors and banks).
3. Working Capital Management
Working capital = Current assets – Current liabilities
A positive working capital means the business can meet its short-term obligations.
Monitoring stock levels, receivables, and payables is essential.
Techniques for Improving Cash Flow
Encourage early customer payments using discounts or incentives.
Use invoice factoring to get cash quickly from trade receivables.
Negotiate extended payment terms with suppliers to delay cash outflows.
Reduce unnecessary costs or defer non-essential spending.
Convert fixed costs to variable costs where possible (e.g. leasing instead of buying).
Increase inventory turnover to release cash tied up in stock.
Tools for Monitoring Profit
1. Income Statement
Records revenues and expenses to calculate:
Gross profit
Operating profit
Profit for the year
Allows management to track changes over time and adjust strategy accordingly.
2. Ratio Analysis
Gross profit margin = (Gross profit / Revenue) x 100
Operating profit margin = (Operating profit / Revenue) x 100
Net profit margin = (Profit for the year / Revenue) x 100
These ratios help identify performance trends and areas for improvement.
3. Break-even Analysis
Helps determine the sales volume needed to cover all costs.
Break-even point = Fixed costs / Contribution per unit
Contribution per unit = Selling price – Variable cost per unit
Used to make decisions about pricing, cost control, and product viability.
Techniques for Improving Profit
Increase revenue through marketing, product development, or pricing strategy.
Reduce costs by negotiating with suppliers, improving efficiency, or automating processes.
Shift focus to higher-margin products or services.
Use technology to reduce labour costs and improve productivity.
Cut down on non-essential expenses without harming output.
The Cash Flow Cycle
Visualising the cash flow cycle helps explain how cash moves through a business and where issues may arise.
Stages in the Cash Flow Cycle
Business purchases raw materials or inventory: cash outflow.
Production and storage: costs are incurred but no sales yet.
Goods or services are sold: revenue is recorded.
Customer pays (sometimes after 30–90 days): cash inflow.
Cash is used to pay suppliers, wages, bills: outflows continue.
If any stage takes too long, particularly customer payments, the business may suffer cash flow problems even when profits look strong on paper.
Using Graphs to Illustrate Cash Flow Cycles
A simple graph can show:
Inflow lines (money received from sales).
Outflow lines (expenses and bills).
Net cash flow (difference between the two at each time point).
These visuals can demonstrate:
When a cash shortfall is likely.
How seasonal variations affect cash needs.
The impact of delays in customer payment.
By understanding this cycle, students can better evaluate business case studies and exam scenarios involving liquidity and solvency.
FAQ
Yes, a business with strong cash flow can still be financially unhealthy in the long term. While positive cash flow indicates liquidity, it doesn't guarantee profitability or sustainable operations. For instance, a firm might generate cash by selling off key assets or borrowing heavily, which boosts short-term cash but damages long-term prospects. If the business consistently operates at a loss, relies on external financing, or neglects investment in innovation and growth, its financial health will deteriorate despite having cash available in the short term.
Seasonal demand can cause cash flow volatility even if profit over the year appears stable. For example, a business might earn most of its revenue during holiday periods but still have fixed costs like rent and salaries year-round. This means cash outflows remain constant, while inflows vary significantly. The business may record annual profit based on total revenue versus costs, but in off-peak months, cash shortages can occur, requiring careful forecasting, budgeting, or access to credit to ensure uninterrupted operations during low-demand periods.
Depreciation is a non-cash expense that reflects the wear and tear or reduction in value of fixed assets over time. It is included in profit calculations on the income statement to match the cost of assets with the revenues they help generate. However, depreciation does not involve an actual cash transaction, so it is excluded from the cash flow statement. As a result, while it reduces reported profit, it has no effect on cash balances and must be added back when calculating cash flow from operations.
Working capital changes — such as increasing inventory, extending credit to customers, or delaying payments to suppliers — directly affect cash flow but not profit. For example, buying more stock uses cash but isn't recorded as an expense until sold, so profit remains unchanged. Similarly, giving customers longer to pay delays cash inflow but still counts as immediate revenue in profit terms. Managing working capital efficiently is vital to maintain liquidity, as these timing differences can create cash shortages despite stable profit margins.
Relying solely on profit figures can mislead lenders or investors about the business's ability to repay loans or deliver returns. Profit may appear healthy due to accounting treatments, while cash flow is negative due to poor receivables collection or over-investment in stock. Investors and banks are concerned with whether the business can meet financial obligations in real time. They often examine cash flow statements alongside profit to assess liquidity, repayment capability, and financial resilience before approving funding or making equity investments.
Practice Questions
Explain one reason why a profitable business might still experience cash flow problems. (6 marks)
A profitable business can face cash flow issues if customers delay payments. For example, offering credit terms such as “30 days to pay” means revenue is recorded immediately, increasing profit, but the cash is not yet received. This creates a timing mismatch between income and actual cash inflow. Meanwhile, the business still needs to pay suppliers, wages, and rent, requiring cash it may not have on hand. As a result, despite appearing profitable on the income statement, the business may be unable to meet short-term obligations, leading to liquidity issues or even potential insolvency without effective cash flow management.
Analyse the impact on a business of confusing profit with cash flow when making financial decisions. (9 marks)
If a business confuses profit with cash flow, it may believe it has more funds available than it actually does. For example, managers might decide to invest in new equipment or hire staff based on high profits, unaware that outstanding customer payments mean cash is unavailable. This could lead to an inability to pay bills or wages, damaging supplier relationships or staff morale. Poor liquidity can also reduce investor confidence or force reliance on costly short-term borrowing. Therefore, understanding the difference between cash flow and profit is essential for maintaining operational stability and making informed financial decisions.
