The difference between profit & cash flow

The difference between profit and cash flow (AO2)

Cash flow refers to the movement of an organization’s cash inflows (cash received from the sale of goods and services) and cash outflows (used to pay for the costs of running the business).

Cash flow is often used to measure the financial health of a business - and is an indicator of the financial health of the economy as a whole. This is because the comparison of cash inflows and cash outflows enables managers to see whether the business is able to pay its costs in order to maintain its operations.

Sales revenue is the value of goods and/or services sold to customers. It is calculated using the formula:

Sales revenue = Price × Quantity

Profit is the value of sales revenue after all costs have been accounted for. This is the money that the business earns. Hence, profit is the positive difference between a firm’s sales revenue and its total costs of production. It is calculated using the formula:

Profit = Sales revenue – Total costs

In other words, the cash accumulated by a business still needs to be used to pay for the costs of production before any profit can be declared. In addition, cash is not necessarily received immediately as some customers pay for their goods and services using trade credit. Although profit is earned when a sale in made (if the selling price is higher than the average costs of production), customers do not necessarily pay by cash as they opt for trade credit instead.

Hence, it is possible for businesses to experience negative cash flow even when they earn a profit. Similarly, it is possible for businesses to have positive cash flow but still experience a financial loss.

Sales revenue can be paid either in cash or as by credit. This means that the firm earns a profit at the time of the transaction (as the price exceeds the costs) but does not necessarily receive the cash at that time, because some customers may choose to pay by trade credit.

Ultimately, a business must have sufficient cash flow to continue operating, whether it is profitable for not.

ATL Activity

The coronavirus pandemic has affected every industry in every country around the world. This creates many opportunities for Business Management students to look into topical case studies of how different organizations are/aren't coping with the crisis.

In April 2020, the British Chambers of Commerce states that more than half of all business in the UK reported cash reserves of three months or less. Without sufficient cash flow, these businesses will simply collapse.

Read this article which explains the cash flow crisis facing businesses in Northern Ireland. Students can then answer the following questions.

The Titanic Museum in Belfast, Northern Ireland

Q1.  What proportion of of businesses in Northern Ireland will run out of cash within the next 6 months?

More than half of all businesses

Q2.  What percentage of businesses have furloughed some or all their staff?

85%

Being furloughed essentially means the workers are on unpaid leave (rather than being made redundant) in order to preserve the cash flow of employers

Q3.  According to the study carried out by the Northern Ireland Chamber and business advisors, what percentage of respondents have more than six months cash reserves?

Only 12%

(and just 2% say they have more than 12 months cash reserves)

Q4.  What has happened to the level of business debt during this period?

It has increased due to the lockdown, i.e. there is no cash inflow for many businesses but there are still ongoing costs that need to be paid

Q5.  What has the government done to support business in Northern Ireland that are facing cash flow problems during the crisis?

Answers could explain the government’s job retention scheme, Statutory Sick Pay Rebate Scheme, and/or Hardship Fund

Return to Unit 3.7 Cash flow homepage

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