Cash Flow

Cash is the money immediately available to a business — in its bank account or as physical notes and coins. It is distinct from other assets such as stock, equipment, or money owed by customers.

A business needs cash to:

• Pay suppliers for raw materials, stock, and services
• Pay employees their wages and salaries
• Cover overheads such as rent, insurance, and utility bills
• Repay loan instalments to lenders
• Fund day-to-day trading (working capital)

Without sufficient cash, a business cannot meet these obligations even if it is technically making a profit on paper. A business that runs out of cash and cannot pay its debts becomes insolvent and may be forced to cease trading.

Key distinction: A business can be profitable but cash-poor. If a business sells goods on credit (customers pay 60 days later), it has earned the revenue but not yet received the cash. Meanwhile, it still has to pay wages and suppliers. This is the most common cause of business failure, particularly in fast-growing firms.

Cash flow refers to the movement of money into and out of a business over a period of time. Managing cash flow is one of the most critical tasks for any business owner.

Cash inflows are all money coming into the business:

• Sales revenue from cash sales
• Payments received from credit customers
• Loans received from banks
• Capital invested by the owner
• Proceeds from selling assets

Cash outflows are all money leaving the business:

• Payments to suppliers for stock and materials
• Wages and salaries
• Rent, rates, and utilities
• Loan repayments (principal and interest)
• Purchase of equipment or machinery
• Tax payments

Formula: Net Cash Flow = Cash Inflows − Cash Outflows

A positive net cash flow means more money is coming in than going out in that period — the business's cash balance grows.

A negative net cash flow means more money is going out than coming in — the cash balance falls. A negative net cash flow is not automatically a crisis; it becomes critical if the opening balance runs out.

Formula: Closing Balance = Opening Balance + Net Cash Flow

The closing balance of one period becomes the opening balance of the next.

A cash-flow forecast is a table that shows predicted inflows, outflows, net cash flow, and balances for each period (usually monthly). Businesses use forecasts to spot future cash shortages before they happen so they can take action in advance.

Worked example — three-month cash-flow forecast:

A small events company starts March with £5,000 in its bank account.

	March	April	May
Cash inflows (£)	8,000	12,000	15,000
Cash outflows (£)	10,000	9,000	11,000
Net cash flow (£)	−2,000	+3,000	+4,000
Opening balance (£)	5,000	3,000	6,000
Closing balance (£)	3,000	6,000	10,000

Verification — row by row:

March: Net cash flow = £8,000 − £10,000 = −£2,000 ✓ Closing balance = £5,000 + (−£2,000) = £3,000 ✓

April: Net cash flow = £12,000 − £9,000 = +£3,000 ✓ Closing balance = £3,000 + £3,000 = £6,000 ✓

May: Net cash flow = £15,000 − £11,000 = +£4,000 ✓ Closing balance = £6,000 + £4,000 = £10,000 ✓

Despite a negative net cash flow in March, the business survives because its opening balance was high enough to absorb it. By May, the cash position has strengthened to £10,000.

Exam tip: Always fill in a cash-flow forecast row by row, top to bottom. Calculate net cash flow first, then use it to find the closing balance. The closing balance of one month is always the opening balance of the next.

Two businesses can have identical profit figures but very different cash positions. Understanding the difference is essential.

Profit is calculated as: Revenue − Total Costs (on an accruals basis — when income is earned and costs are incurred, not when cash changes hands).

Cash is actual money physically available right now.

Example — why profitable businesses run out of cash:

A furniture manufacturer sells a batch of chairs for £20,000 on 90-day credit. The revenue appears in the profit and loss account immediately, but the £20,000 cash does not arrive for three months. In the meantime, the business must pay its staff, buy timber, and pay rent — all in cash. It may run out of money before the customer pays.

Situation	Cash Position	Profit Position
Sold on credit (customer hasn't paid yet)	Cash not received yet	Revenue recorded
Bought stock and paid immediately	Cash reduced	Cost recorded
Received a bank loan	Cash increased	Not profit
Owner invests personal savings	Cash increased	Not profit

Overtrading is a particular risk for fast-growing businesses. As a business wins more orders, it spends more on supplies and wages before the customer pays. Cash is consumed faster than it arrives, even though the business looks profitable on paper.

Understanding why cash flow problems arise allows businesses to take appropriate action.

Common causes:

• Low sales — fewer customers means less cash coming in
• Seasonal demand — a toy shop receives most revenue in December but pays costs year-round
• Slow-paying customers — long credit periods delay cash inflows
• Overstocking — buying too much stock ties up cash in unsold goods
• Unexpected costs — equipment breakdown, emergency repairs
• Rapid growth (overtrading) — growth consumes cash faster than revenue arrives

Solutions:

Problem	Possible Solution
Customers paying slowly	Reduce credit terms; offer early-payment discounts
Too much stock	Reduce order quantities; use just-in-time stock management
Seasonal cash shortages	Arrange an overdraft facility for quiet months
Unexpected expenses	Maintain a cash reserve (contingency fund)
Short-term cash shortfall	Negotiate trade credit with suppliers
Long-term cash shortage	Seek a bank loan or additional investment

Reducing outflows is as effective as increasing inflows. Negotiating longer payment terms from suppliers (trade credit) means cash stays in the business longer before leaving.

Examiners frequently ask students to analyse a given cash-flow forecast and evaluate the business's financial health.

What to look for:

• Is the closing balance positive or negative? A negative closing balance means the business cannot cover its obligations — it needs an overdraft or injection of funds.
• Is there a trend? A business with declining closing balances each month faces growing financial stress.
• Which months have negative net cash flow? Understanding why (seasonal dip, one-off investment) helps assess whether the problem is temporary or structural.

Worked interpretation question:

"A business has closing balances of £2,000, −£1,500, and −£4,000 over three months. Evaluate whether the business is likely to survive."

Analysis: The balance turns negative in month 2 and worsens in month 3. The business cannot pay its debts as they fall due. Without intervention (overdraft, additional capital, cost cuts), insolvency is a real risk. However, if the negative cash flow is caused by a one-off investment (buying a new machine), future months may recover. The business needs to act before month 2 closes.

Exam tip: In evaluation questions, consider both the short-term and long-term outlook. A temporary negative cash flow is manageable; a sustained one is not.

1. Never skip the opening balance row

Many students jump straight to net cash flow and forget to carry the previous month's closing balance forward as the new opening balance. This cascades errors through the whole forecast.

2. Net cash flow can be negative — that's fine to write

A negative net cash flow of −£2,000 should be written as "−£2,000" or "(£2,000)". Don't avoid the negative sign.

3. Cash flow ≠ profit

Cash received from a bank loan increases cash but is not profit. Sales made on credit increase profit (in accounting terms) but don't immediately increase cash. These two concepts are examined separately — never conflate them.

4. Distinguish between short-term and long-term problems

An overdraft is a short-term fix. If cash flow problems are structural, the business needs a longer-term solution such as securing a loan or cutting fixed costs.

Common Exam Error	Correct Approach
Treating the opening balance as zero	The opening balance is given in the question (or is the prior month's closing balance)
Adding net cash flow to the wrong balance	Closing = Opening + Net cash flow (not the other way round)
Saying a profitable business cannot have cash problems	Cash and profit are different — profitable businesses fail due to cash shortages
Forgetting to label negative values with a minus sign	Always show the sign; −£2,000 ≠ £2,000