Cash Flow & Working Capital (DP IB Business Management)

The Difference Between Profit & Cash Flow

• Profit and cash are different financial terminologies

  • Profit is calculated at a specific point in time

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

• 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 sustainability 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

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

  • Cash-poor businesses will struggle to pay suppliers

    • E.g. 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

Working Capital

• Working capital is the money that a business has available to fund its day to day activities

• It is sometime included as net current assets on the Statement of Financial Position

• Working capital is calculated using the formula 

Working capital = Current assets - Current liabilities

 Managing working capital

• Working capital is described as the lifeblood of a business because a lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations

  • Cash is the most liquid of a business's current assets and can be used to settle debts immediately 

• Effective management of working capital involves careful cash management

  • Debtors and stock are less liquid

  • Businesses that are struggling with a lack of working capital may look to convert these current assets into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully chasing payment from customers)

  • Requesting an extension of payment terms from suppliers can increase working capital in the short term as cash remains in the business for longer

  • Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation as it can access more cash than it has in its current account  

• A business can have too much working capital

  • If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments

  • This may represent a significant opportunity cost especially when interest rates are high

  • If a business is holding large amounts of stock it may incur extra storage costs (e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for other purposes

Liquidity Position

• The Statement of Financial Position contains the financial information required to draw conclusions about the liquidity of the business

  • Liquidity is the ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets

  • A business that cannot pay its bills will usually fail very quickly, even if they are profitable

  • Managing liquidity is a key way to manage risk in a business - and helps a business to prepare for the unexpected